Let’s start the end of the week on the other side of the world, then work our way back.
Greece is the focus…again. Will they or won’t they?
Default, that is.
Who knows? This saga has been dragging on so long that all the Greek clichés and references to Greek mythology have been used twice over. There’s nothing original left to say.
Next week marks yet another crunch time. Greece owes the International Monetary Fund (IMF) €750 million, a pretty small payment in the scheme of things. But it’s raising concerns about Greece’s ongoing ability to meet creditor repayments.
Over the past few weeks, the narrative has changed from that of hard line creditors demanding repayment in full to talk of debt write-offs to ease Greece’s debt burden. That’s because it’s clear that Greece will need another ‘bailout’ when this one ends in June. It’s never-ending.
Talk of debt write offs, an issue raised recently by the IMF, is at least sensible. Greece can never repay its debt nor have a functioning economy while it labours under such a huge burden.
But debt write offs are not easy to pull off politically. Equity markets are no longer too concerned about Greece because all the problem debts now sit with the IMF, the European Central Bank, and the European Stability Fund. In other words, they’re liabilities of the various governments that support these entities.
This is where the recent bond sell-off comes into play. I really have no idea why government bond yields around the world have all risen sharply over the past week or two. So this is just a theory…
But what if investors see what’s happening in Greece as a blueprint for the future. That is, a path to growth for indebted countries is not austerity and deflation but debt write-offs and inflation?
If this is an emerging market narrative, then government bond yields around the world are way too low. They’re priced for a secular deflationary environment and very little balance sheet risk.
Let me explain…
If Greece manages to pull off debt forgiveness, or just defaults on its debt outright, its debt burden doesn’t disappear. It transfers onto the balance sheets of various governments…most notably Germany.
The private sector is off the hook. It’s the public sector that now bears the cost. That’s an increased risk…a risk that yields are not pricing in.
Let’s take a look at the recent movement in German debt. The 10-year German bond yield is the benchmark. On 20 April it reached a low of 0.07%. That is, you lend to the German government for 10 years and get an annual yield of 0.07%. I know, it’s crazy.
I don’t know whether it’s a coincidence or not, but a day after the low, on 21 April, an article appeared in the Greek newspaper, Ekathemerini.
‘The Greek government’s mounting financial woes are leading it to contemplate the unthinkable: defaulting on a loan from the International Monetary Fund. Instead of demanding repayment and further austerity, the IMF should recognize its responsibility for the country’s predicament and forgive much of the debt.
‘Greece’s onerous obligations to the IMF, the European Central Bank and European governments can be traced back to April 2010, when they made a fateful mistake. Instead of allowing Greece to default on its insurmountable debts to private creditors, they chose to lend it the money to pay in full.
‘At the time, many called for immediately restructuring privately held debt, thus imposing losses on the banks and investors who had lent money to Greece. Among them were several members of the IMF’s board and Karl Otto Pohl, a former president of the Bundesbank and a key architect of the euro. The IMF and European authorities responded that restructuring would cause global financial mayhem. As Pohl candidly noted, that was merely a cover for bailing out German and French banks, which had been among the largest enablers of Greek profligacy.’
Since then, the yield on German bonds has jumped to 0.59%. Certainly not emergency levels, but it’s still a decent move over just a few weeks. Given the perception that German bonds are amongst the safest in the world, other bonds have moved north also, including Australian government bond yields.
Aussie 10 year bond yield bottomed on 14 April at 2.31%. Since then, they’ve increased to around 3%. That’s despite the RBA cutting the official cash rate this week to 2%.
Again, that’s no big deal. It brings the Aussie bond yield back to where it was in December 2014. More than anything, the fall in yields since mid-April probably reflects the big rally in the iron ore price.
Iron ore is Australia’s most important commodity and when it plunged to a new low in mid-April, it risked dragging Australia into a recession…hence the plunge in bond yields.
Still, despite the local influences, it’s not a coincidence that government bond yields around the world are on the rise. This could be the early stages of a subtle shift away from a deflationary mindset and towards one of future inflation.
I don’t think it’s a shift you can necessarily trade. In fact, government yields are probably due to fall in the short term given the recent sell-off was so sharp. But it’s worth keeping in mind that we could be at a long term turning point.
The great government bond bull market may be finally over…having peaked with negative interest rates in some cases and panic about deflation ‘forever’. But the history of money and financial markets tells you that over the long term, you should always bet on inflation. Inflation is the easy way out…and it’s the way human societies have dealt with monetary problems for millennia.
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