Is Mr (Bond) Market in Charge?

Jim Stewart: (The Governor of the Central Bank, Patrick Honohan is quoted as stating to the Oireachtas Committee on Economic Regulatory Affairs :- “though we may not like it, we have to jump to what the lenders expect and convince lenders we can get to the situation where debt is not spiralling out of control”).

The interest paid or yields on Irish Government debt have soared in the past two weeks. The yield on ten year debt is nearly 9%, below that of Greece at 11.6% and above that of Portugal at 7.2%. The economic problems of Ireland, Greece, Portugal and Spain are regularly discussed as being at the centre of ‘investor concerns’ (New York Times, November 7). There is renewed speculation about the break up of the Euro, re-adoption of national currencies and devaluation (Victor Mallet and Peter Wise, Financial Times November 8). The rise in bond yields in the peripheral countries of Europe caused the Euro to fall against the dollar and stock markets to fall on Monday, Tuesday and Wednesday of this week according to the Financial Times (Financial Times, November 9,10,11).

Yet at the same time, bond prices in many other countries are at historic highs, yields are at historic lows. The real yield on inflation-linked 5 Year UK bonds is -0.44%. Despite low interest rates, falling yields and rising prices have meant that returns on, for example, German and US government debt have been over 8% so far this year (Keith Jenkins, Bloomberg, November 8) This has led to considerable debate as to whether there is a bubble in bond markets. (See for example:- Financial Times, October 31). Much media attention focuses on the price of gold - up over 30% in the past year - but commodity prices have risen even more:- sugar is up 40%, corn 55%, cotton 76%. These prices, if sustained, will result in higher inflation. Hence it is likely that long term bond yields in countries such as Germany will rise.

Why have interest rates on government debt in peripheral countries risen so high so quickly? In the case of Ireland, the cost of the bank bailout and resulting Government borrowing requirement has been roughly known for some time, and yet the markets are only reacting now.

One factor is undoubtedly due to German Government policy which led to what Der Spiegel (8 November) has referred to as the ‘Merkel crash’. That is the proposal, apparently agreed to by the European Council at the instigation of the German Government, that bond holders would suffer losses in the event of a country borrowing from the European Financial stability Facility. The Financial Times recently reported this decision as agreement on “an automatic” default by borrowing countries (David Oakley and Richard Milne, November 9). However the European Council press release of conclusions at its meeting merely agreed to ‘endorse’ the Van Rompuy report. The Van Rumpuy proposals are however aspirational. The only phrase include the word automatic is in par. 26, as in ‘increasing the automaticity’ of decision making.

Much more serious was Merkel’s statement that a new bankruptcy mechanism will be established which will ensure private investors bear some of the costs in any future crisis. The German finance minister recently stated in relation to the crisis mechanism, “we are working out the details within the German Government and at the European level. Its already clear today that the new mechanism will not apply to old debt but only to new debt” (Der Spiegel 11/8/2010). These policy statements are more likely to be driven by domestic German concerns (politicians cannot be seen to be bailing out the feckless Greeks and Irish by the virtuous Germans with ‘Swabian’ housewife values) than by broader issues relating to financial and economic crisis in eurozone and other countries.

Partly as a result, it is not clear what rules will emerge and how bondholders both new and old might be affected. Commentators have conflicting versions of what the German Government proposes and what might be implemented at EU level.

German Government proposals have created uncertainty and bond yields have risen as a result. This was indeed forecast at the meeting of the Council of Ministers (29 October) by the President of the ECB (See Jack Farchy, Financial Times November 9).

But the sudden rise in bond yields is also due to other factors. The President of the ECB is also quoted as stating that, by encouraging short selling of bonds of those countries with large deficits, they are facilitating ‘US speculators’. The relationship between rising debt costs and hedge funds/speculators has also been made by others. Speculation against eurozone bonds may be linked with beliefs in relation to the break-up of the eurozone.


The Trading Strategy of Hedge Funds

Credit Default Swaps (CDS) may be an integral part of the trading strategy of hedge funds (very large investment funds, for example Soros Fund Managers with assets of €27 billion, which are typically highly leveraged, lightly regulated, and limited to a small number of large investors). CDS provide insurance on the underlying debt asset but also allow speculative trading because CDS contracts do not require any insurable interest (an analogy is with rival criminal gang members taking out life insurance on their opponents).

There is a positive correlation between yield on debt and Credit Default Swaps. For example the yield on Irish government debt will approximately equal the cost of a CDS plus the risk free rate that is the yield on German Government debt of the same maturity.

Y on Irish debt = CDS cost + risk free yield (German Bund yield) or

CDS cost = Y – risk free yield.

If the cost of a CDS rises, the yield on government debt rises. The market for CDS and Irish Government bonds is narrow (New York Times 10 November) and the market for Government debt has become more illiquid. The collateral requirements of those trading Irish Government debt increased on 10th November, meaning those trading Irish Government debt had to post higher margins or sell debt. The Financial Times (11/11/2010) reports the Bank of Ireland chose to post higher margins requiring extra cash of €250 million. The net effect is that liquidity and trading in Irish government debt will be further reduced. In addition most bonds are held to maturity. A sudden demand for CDS will drive up the price and drive down the price of bonds. Holders of CDS swaps on Irish Government debt purchased some weeks ago have now large gains. Holders of Irish Government debt have large losses. This has implications for example for banks, pension funds, etc., to the extent that they have suffered and realised losses on their holdings of Irish Government debt.

Implications

Irish and other countries’ bond yields are a function of hedge fund trading strategies. Hedge funds thrive on uncertainty. Part of their strategy is to create uncertainty by media reports, ‘research’, etc. One widely cited report on Bloomberg asserted that Ireland was going bankrupt, would run out of cash in 60 days, and that debt restructuring of peripheral countries as proposed by Germany would mean “the whole thing is gone”. In contrast, the NTMA state they have sufficient cash reserves to fund the projected government deficit until June/July 2011 and furthermore do not need to refinance debt until November 2011.

Strategies pursued by hedge funds have driven up yields. High yields means the Irish and other Governments are in effect shut out of the bond market. The recently announced extension of the guarantee on bank debt is meaningless, as bank debt guaranteed by the State is unlikely to have a lower cost than the cost of debt issued by the State. The Irish State is currently the only possible source of long term funds.

An election would reduce uncertainty, but other uncertainties remain. For example, a continuing decline in property values, failure to obtain economic value from the large stock of existing housing, hotel and other assets will mean further capital losses by banks, company insolvencies, negative equity, etc.

Yields once driven up are likely to be ‘sticky’. Even if they fall likely to a large premium over German Government bonds is likely to remain.

Use of the Economic Financial Stability Facility (ESFF) by any country is likely to be conditional on rules for this fund. Rules that exempt existing bond holders, but seek to impose losses on new bond holders (debt restructuring and write downs), may simply ensure that the interest cost of debt in peripheral countries remains high and countries such as Ireland may cease to be able to borrow. Hence the only source of debt will be from the ESFF.

The loss of control by the Irish Government of policy decisions, while predictable, has suddenly arrived. But it is not inevitable that bond markets determine policy. EU rules in relation to the use of the ESFF have yet to be determined. Policies that equate macroeconomic management with the economics of households (the ‘Swabian’ housewife) can and should be countered. Restrictions should be imposed on the use of Credit Default Swaps. Earlier this year, the French Economy Minister was quoted as being in favour of restrictions on the use of Credit Default Swaps. One effect of ECB policies of providing liquidity at low cost to the banking sector is that such liquidity can be used to speculate against sovereign debt, but the ECB is prohibited from lending directly to sovereign states.

Ireland would not be alone in making these arguments.