from Follow the Money

The Economist asks: Where have all the bond market vigilantes gone?

August 19, 2005

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And more importantly, has the replacement of bond market vigilantes constantly searching for any indication inflation is coming back and penalizing any weakness in a country's public finances with forgiving souls seemingly unconcerned with unprecedented imbalances a good thing?

The Economist says no, it is not a good thing.   The world's bond markets are letting too many economic sins go unpunished for too long. 

Listen to Maurice Obstfeld:

The liquidity and risk structure of US deficit financing would give an emerging market finance minister sleepless nights, and would have generated concern even in the US during the Bretton Woods era ...  the prospect of such developments would have once sent financial markets reeling, market actors now seem to be accepting the extent and nature of US borrowing, and the prospect of its indefinite continuation, with equanimity.

Actually, the bond market now seems to reward what in the past would have been considered sins.   The US fiscal deficit (long-term) and US current account deficit are far larger in 2004 and 2005 than they were in 1999 and 2000.  But yields on Treasuries should be far lower now than they were then.   After all, with so much spare savings sloshing around, the bond market has to push rates down to the point where the US Congress is almost forced to spend more (or cut taxes), and provide enough Treasuries to the world to absorb the global savings glut ...


Italy has a larger stock of government debt than the other major emerging economies?  Hey, that is no reason why yields on Italian bonds should not be the same as yields on German bonds.  A euro-denominated government bond is a euro-denominated government bond. 

Yields on government bonds barely differ, despite differences in countries' fiscal health. In the early 1990s, yields on ten-year government bonds were 450 basis points higher in Italy than in Germany. Today Italy pays a penalty of only around 20 basis points, even though its ratio of public debt to GDP is almost twice Germany's. Such thin interest-rate spreads give governments little incentive to trim their deficits.

And the convergence trade that paid off so well in Italy should work for Turkey too - who cares if Turkey is not going to get in to the EU, let alone the eurozone, any time soon.  Ok, the last argument is a tad unfair: with short-term Eurozone rates around two, the yields on Turkish lira denominated Treasury bills are just really juicy.  There is no need to make any long-term bet on Turkey to profit from the carry trade.

The cost of all this?   According to the Economist, imbalances are allowed to get bigger, making the eventual adjustment all the more costly.    Obviously that argument appeals to me.

One possible explanation for the disappearance of market vigilantes:  the emergence of a global financial market, which allows countries to draw on global savings to build up larger stocks of debt.    Theoretically, a fiscal deficit has a smaller impact on domestic interest rates in an open economy than in a closed economy.  In a closed economy, big fiscal deficits crowd out private investment.   In an open economy, a small rise in interest rates leads global savings to flood in to finance the fiscal deficit without much of a fall in private investment.   You can have big tax cuts, large structural deficits and a real estate boom (bubble) too ...

Another explanation.  Short memories.  Anyone who bought a long-term US government bond in say 1983 made a lot of money.   Anyone who bought US government bonds in 2000 made a lot money.   The same is true with "spread" products recently.   Credit spreads have collapsed.  But anyone who bought a long-term US government bond that paid less than 6% in early 1972 lost a lot of money, as interest rates rose toward 14% in the early 80s.  See this chart.

One risk.  Markets have been known to shift moods rather suddenly.  The market was every bit as willing to finance current account deficits in most emerging economies in 1996 and 1997 as it is now willing to finance US real estate.   That all changed in 1998.    Of course, the market's mood may shift more suddenly and more destructively for small economies than for the world's biggest economy.   But it is still a risk.  Obstfeld again: "The fluid international capital markets may be extending to the US, at low interest rates, a longer rope from which to hang later on."

Another risk.  The dollar carry trade looks to be on its last legs.   Short-term US rates are rapidly converging toward long-rates.   That squeezes banks that borrow short and lend long.  It should squeeze hedge funds as well.  They borrow short to bet on short-term market moves, and their cost of funding (at least in dollars) has gone up.   Moreover, the slow predictable rise in rates over the past year has encouraged folks in the market to bet on further slow, predictable rises in rates.  That reduced the risk of certain kinds of bets.   In other words, making money used to be easy.   Borrow short, lend long.  Bet on curve flattening.  Bet on spread compression.   But those trades look to be on their last legs.  That raises my long-standing concern: to try to make big bucks in a much more difficult environment, someone somewhere may gear up, double up on their bet and bet wrong ...

A final risk.  Many buying long-term debt (or going long credit risk in the credit default swap market) are making what amounts to a short-run bet on the direction of the market, or on the convergence or divergence of the prices of two different securities.   There are not all that many buy and hold investors in parts of the fixed income market.   Most of the time, markets are deep and liquid and investors can sell bonds they don't want easily.  But not all the time.  And the more exotic the instrument (and the more untested the market in times of real stress), the greater the risk.    The credit default swap market is not what is used to be -

While any given investor can get out by selling to another investor, in aggregate, someone still has to hold the bonds.  And sometimes, it can be hard to find buyers.

Look at the stylized dynamics of financial crises laid out by the counter-party risk management group.

"A triggering event or events ... causes sharp and sudden declines in one or more classes of assets."

"[The fall is] sufficiently steep to raise questions about the creditworthiness of major counterparties or institutions"

"The analytical distinction between market risk and credit risk blurs as market risk and credit risk feed on each other."

"Pressure on assets prices ... in turn trigger[s] the initial evaporation of market liquidity for one or more classes of assets."

"The evaporation of asset liquidity aggravates both market and credit risk and begins to call into question the balance sheet liquidity for some institutions"

"Seemingly generous amounts of margin and collateral are rapidly called into question ... dramatically elevating credit concerns. ..."

"The escalation of credit concerns further influences the defensive behavior of financial market participants, all of which acts to reinforce the cumulating adverse market dynamics.   A financial crisis with potential systemic effects is at hand."

I am a bit more inclined to worry than the Wall Street Journal oped page.  I suspect the new Fed chairman will be tested at some point, in a big way.

UPDATE:  For a slightly different take -- one arguing there is no reason to expect the markets to push up long-term interest rates in the face of global  imbalances so long as US short rates were low -- see the Skeptical Speculator.

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