Michael Taft: It is difficult to come to a judgement on the NTMA bond sale. That we entered the bond market accessing new money is a plus, especially against a backdrop of yet another twist in the Eurozone crisis. That it builds up liquidity assets in anticipation of a large bond redemption in January 2014 is another plus. However, there are downsides and disappointments.
NamaWineLake compares the costs of the new bonds with borrowings from the EU-IMF bailout and finds that it will cost us nearly €1 billion more in interest payments up to 2020. However, this may not be the best comparator as it is the intention to exit the EU-IMF deal late next year. To test the water, so to speak, was always going to prove expensive at first.
There are two better comparisons. First, how do the interest rates compare with the secondary market? On the day of the bond sale, this is how the comparison stood using Bloomberg data.
For the 5-year bond (raising €3.9 billion):
• Bond sale: 6.1 percent
• Secondary market: 5.3
For the 8-year bond: (raising €1.3 billion):
• Bond Sale: 6.1 percent
• Secondary market: 6.2 percent
The majority of funds (from the 5-year bond sale) were borrowed at rates that compare badly with the secondary market. This is a disappointment. The 8-year sale just beat the interest rates on the secondary market.
Another comparison is with the beginning of 2010 – the year we started sliding into the bail-out with interest rates getting out of control. However, at the beginning of the year out interest rates were sustainable, though still high by comparison with most other EU-15 countries.
For the 5-year bond sale:
• Bond Sale: 5.9 percent
• January 2010: 3.3 percent
For the 8-year bond sale:
• Bond Sale: 6.1 percent
• January 2010: 4.5 percent
Again, the 5-year bond compares badly while the 8-year comparison shows a significant gap.
Can we close these gaps on a permanent basis by the end of next year? The only thing we can conclude from last week’s intervention is that we have a long, long way to go.
Showing posts with label bond market. Show all posts
Showing posts with label bond market. Show all posts
Monday, 30 July 2012
Monday, 9 January 2012
Irish Bonds Tempt Buyers Again After Banks Blow Up: Euro Credit
Sheila Killian: There’s an interesting article on Bloomberg, by Dara Doyle and Cormac Mullen. Interesting, that is, in the Confucian sense of living in interesting times.
The initially rather bizarre gist of the article is that for potential bondholders, the banks that we have bailed out are now a far more attractive investment proposition than the Irish government which guarantees them. They are producing a higher yield, which is counterintuitive if you take the view that they have the same risk, since we are underwriting them.
Here’s a quote from the article:
“Essentially, you are getting more than twice the yield for the same amount of risk,” said Fergal O’Leary, a director at Dublin-based fixed-income firm Glas Securities. “The government bond is undoubtedly more liquid than the guaranteed bank security, but that just doesn’t justify the current scale of the yield premium.”
Indeed not. So what does? Well, perhaps the market, in its anthropomorphised all-knowingness doesn’t actually “think” they have the same risk. Perhaps it “thinks” that for some reason Irish bank bonds are riskier than Irish government bonds, despite the government’s willingness to guarantee them. Another quote, this time from a billion-pound fund manager based in the UK:
“I don’t see how they will be able to maintain that guarantee, or at least there’s a risk that they won’t, and certainly the chances of a default on the bank debt are significantly more than on the sovereigns,” Bathgate said by e- mail yesterday. “The risk return just doesn’t add up.”
So it looks as though investors don’t really believe that the government will ensure that all the bank bonds are repaid. It looks as though that might already be priced into the yields of these bank bonds. In which case, perhaps, we should look again at the unguaranteed bonds coming up later this month, and consider what’s really to be gained or lost, by paying them.
The initially rather bizarre gist of the article is that for potential bondholders, the banks that we have bailed out are now a far more attractive investment proposition than the Irish government which guarantees them. They are producing a higher yield, which is counterintuitive if you take the view that they have the same risk, since we are underwriting them.
Here’s a quote from the article:
“Essentially, you are getting more than twice the yield for the same amount of risk,” said Fergal O’Leary, a director at Dublin-based fixed-income firm Glas Securities. “The government bond is undoubtedly more liquid than the guaranteed bank security, but that just doesn’t justify the current scale of the yield premium.”
Indeed not. So what does? Well, perhaps the market, in its anthropomorphised all-knowingness doesn’t actually “think” they have the same risk. Perhaps it “thinks” that for some reason Irish bank bonds are riskier than Irish government bonds, despite the government’s willingness to guarantee them. Another quote, this time from a billion-pound fund manager based in the UK:
“I don’t see how they will be able to maintain that guarantee, or at least there’s a risk that they won’t, and certainly the chances of a default on the bank debt are significantly more than on the sovereigns,” Bathgate said by e- mail yesterday. “The risk return just doesn’t add up.”
So it looks as though investors don’t really believe that the government will ensure that all the bank bonds are repaid. It looks as though that might already be priced into the yields of these bank bonds. In which case, perhaps, we should look again at the unguaranteed bonds coming up later this month, and consider what’s really to be gained or lost, by paying them.
Tuesday, 30 August 2011
Falling Irish bond yields
Michael Burke: Irish bond yields are falling. At the time of writing, the yield on 10yr bonds is 8.65%. This is down from the peak of 14.22% on July 15. Yields are inversely related to prices, so bonds have been appreciating sharply. According to Financial Times’ data the benchmark 10yr bond has increased in value by over 40% since mid-July and currently trades at over 76 cents in the Euro, up from less than 54 cents.
Irish government debt is a ‘spread market’, one in which its price is mainly derived from its relative value to other Euro-denominated government debt markets. Therefore, the change in the relative value of Irish government debt is a more important marker of specific factors affecting perceptions of the Irish economy and fiscal position.
The absolute peak in Irish yields coincided with their peak spread over German bunds of 1134bps (basis points, or 11.34%). This was also the peak in the spread of Italian government bonds, known as BTPs. Then the yield spread was 828bps. One week later the Irish yields had fallen to 11.89% and the respective yield spreads over bunds and BTPs had narrowed to 906bps and 648bps. Put another way, while Irish yield were plummeting, German yields were actually heading higher and Italian yields were only falling very modestly.
But that pattern has not persisted, even though Irish yields continue to fall dramatically. Yields on all 3 bonds fell until August 18, when Irish yields reached 9.74%, bunds touched 2.09% and BTPs dipped to 4.95%, for spreads of 765bps and 479bps respectively. Since that time both bund and BTP yields have edged higher but Irish yields have continued to fall. By close of trading last week Irish 10yr yields were 8.82% and bund and BTP yields were 2.23% and 5.09% respectively. In little more than a month the nominal level of Irish yields has fallen by 540bps and the yield spreads have nearly halved over both bunds and BTPs.
Clearly, Irish government debt has participated in a general rally in European government bonds. (In Britain, the post-Iraq BBC is very anxious to support government policy, which it assumes is Eurosceptic and so continues to ascribe stock market declines to the EU debt crisis. It hasn’t noticed either that European debt markets have been rallying while stocks fell or that the current government, fearing a financial apocalypse, has turned Euro-federalist).
Irish Rally
But Irish government debt has also evidently been enjoying a rally of its own, with yields falling more sharply than in other markets and continuing to fall even when others have turned.
It can’t be the ‘recovery’ as the national accounts data, showing a rise in GDP but slump in all categories of domestic demand, was published on June 23- and yields and spreads continued to rise thereafter. It’s tempting to suggest that the all-clear from the Troika was the cause.
But that was released on July 14, and the yields jumped 35bps immediately afterwards. Similarly, much commentary is devoted to the improvement in government finances in the first few months of this year. But the July Exchequer returns (which only provide a partial picture) show the year-to-date deficit at €9bn compared to €7.4bn in the same period in 2010.
There can be little doubt that Ireland has benefited from the ECB’s announcement of bond purchases, which has helped all the crisis-hit countries and now amounts to €116bn. But the announcement was made on August 7, long after the Irish bond rally had begun and so can have only helped it on its way.
Similarly, the reduction in the interest rate on Irish bailout funds will have provided strong support. The summit, 2 weeks after the bond rally began saw the protracted struggles in Greece lead to a reduction in interest rates for both Portugal and Ireland. (The interest rate cut owes nothing to the negotiating skills of the Irish government, as they repeatedly said they weren’t negotiating with EU partners on this point, simply arguing to keep ultra-low corporate taxes). This is the first significant improvement in the fiscal position since the crisis began and will have helped support the rally.
But the catalyst for the rally was something else. The widely-discredited EBA bank stress tests were published on July 15. No matter that the EBA’s entire estimate for European bank recapitalisation was exceeded by the failure of Spanish savings banks just days later, the relief to holders of Irish government debt was the belief that no further state funds would be needed to recapitalise the banks. It was then that the rally began.
Irish sovereign debt is more closely tied to the banks than any other Euro Area economy. So the idea that there will be no further drain from this source underpins the specific rally in Irish government debt. But it might be mistaken. There is an ideological commitment here to placing the interest of the rentiers ahead of those of the economy- the opposite of Keynes’s dictum. And the situation may well deteriorate, as NAMA’s losses tend to indicate. The ‘deleveraging’ process at the domestic banks will leave with an increased dependence on the fortunes of the domestic economy. If the domestic economy fails to recover, bad debts will mount as seems to be happening already in the mortgage market. It is also unclear whether bond investors understand the actual liability to Anglo, where only €3.1n has been borrowed of a projected €47bn requirement to cover promissory notes.
Conclusion
The bond rally was sparked by the idea that no more funds would be needed for the banking system. It has been underpinned by ECB bond buying and the cut in interest rates. But unless the domestic economy recovers, the faith that no further bank bailouts are likely could be misplaced.
Does the rally bring debt sustainability closer? Yes, but it still remains very far away. For debt sustainability the real interest rate minus the real growth rate multiplied by the debt/GDP ratio must be lower than the primary budget balance (primary, meaning before debt interest payments are included). As the debt/GDP ratio is approximately 110% and the primary budget balance approximately -7% of GDP, the current numbers need to go into reverse. What’s needed is 1% yields and 8.7% growth, or a similar gap between the two. Otherwise, rising debt interest payments threaten to overwhelm government finances over the medium-term.
Irish government debt is a ‘spread market’, one in which its price is mainly derived from its relative value to other Euro-denominated government debt markets. Therefore, the change in the relative value of Irish government debt is a more important marker of specific factors affecting perceptions of the Irish economy and fiscal position.
The absolute peak in Irish yields coincided with their peak spread over German bunds of 1134bps (basis points, or 11.34%). This was also the peak in the spread of Italian government bonds, known as BTPs. Then the yield spread was 828bps. One week later the Irish yields had fallen to 11.89% and the respective yield spreads over bunds and BTPs had narrowed to 906bps and 648bps. Put another way, while Irish yield were plummeting, German yields were actually heading higher and Italian yields were only falling very modestly.
But that pattern has not persisted, even though Irish yields continue to fall dramatically. Yields on all 3 bonds fell until August 18, when Irish yields reached 9.74%, bunds touched 2.09% and BTPs dipped to 4.95%, for spreads of 765bps and 479bps respectively. Since that time both bund and BTP yields have edged higher but Irish yields have continued to fall. By close of trading last week Irish 10yr yields were 8.82% and bund and BTP yields were 2.23% and 5.09% respectively. In little more than a month the nominal level of Irish yields has fallen by 540bps and the yield spreads have nearly halved over both bunds and BTPs.
Clearly, Irish government debt has participated in a general rally in European government bonds. (In Britain, the post-Iraq BBC is very anxious to support government policy, which it assumes is Eurosceptic and so continues to ascribe stock market declines to the EU debt crisis. It hasn’t noticed either that European debt markets have been rallying while stocks fell or that the current government, fearing a financial apocalypse, has turned Euro-federalist).
Irish Rally
But Irish government debt has also evidently been enjoying a rally of its own, with yields falling more sharply than in other markets and continuing to fall even when others have turned.
It can’t be the ‘recovery’ as the national accounts data, showing a rise in GDP but slump in all categories of domestic demand, was published on June 23- and yields and spreads continued to rise thereafter. It’s tempting to suggest that the all-clear from the Troika was the cause.
But that was released on July 14, and the yields jumped 35bps immediately afterwards. Similarly, much commentary is devoted to the improvement in government finances in the first few months of this year. But the July Exchequer returns (which only provide a partial picture) show the year-to-date deficit at €9bn compared to €7.4bn in the same period in 2010.
There can be little doubt that Ireland has benefited from the ECB’s announcement of bond purchases, which has helped all the crisis-hit countries and now amounts to €116bn. But the announcement was made on August 7, long after the Irish bond rally had begun and so can have only helped it on its way.
Similarly, the reduction in the interest rate on Irish bailout funds will have provided strong support. The summit, 2 weeks after the bond rally began saw the protracted struggles in Greece lead to a reduction in interest rates for both Portugal and Ireland. (The interest rate cut owes nothing to the negotiating skills of the Irish government, as they repeatedly said they weren’t negotiating with EU partners on this point, simply arguing to keep ultra-low corporate taxes). This is the first significant improvement in the fiscal position since the crisis began and will have helped support the rally.
But the catalyst for the rally was something else. The widely-discredited EBA bank stress tests were published on July 15. No matter that the EBA’s entire estimate for European bank recapitalisation was exceeded by the failure of Spanish savings banks just days later, the relief to holders of Irish government debt was the belief that no further state funds would be needed to recapitalise the banks. It was then that the rally began.
Irish sovereign debt is more closely tied to the banks than any other Euro Area economy. So the idea that there will be no further drain from this source underpins the specific rally in Irish government debt. But it might be mistaken. There is an ideological commitment here to placing the interest of the rentiers ahead of those of the economy- the opposite of Keynes’s dictum. And the situation may well deteriorate, as NAMA’s losses tend to indicate. The ‘deleveraging’ process at the domestic banks will leave with an increased dependence on the fortunes of the domestic economy. If the domestic economy fails to recover, bad debts will mount as seems to be happening already in the mortgage market. It is also unclear whether bond investors understand the actual liability to Anglo, where only €3.1n has been borrowed of a projected €47bn requirement to cover promissory notes.
Conclusion
The bond rally was sparked by the idea that no more funds would be needed for the banking system. It has been underpinned by ECB bond buying and the cut in interest rates. But unless the domestic economy recovers, the faith that no further bank bailouts are likely could be misplaced.
Does the rally bring debt sustainability closer? Yes, but it still remains very far away. For debt sustainability the real interest rate minus the real growth rate multiplied by the debt/GDP ratio must be lower than the primary budget balance (primary, meaning before debt interest payments are included). As the debt/GDP ratio is approximately 110% and the primary budget balance approximately -7% of GDP, the current numbers need to go into reverse. What’s needed is 1% yields and 8.7% growth, or a similar gap between the two. Otherwise, rising debt interest payments threaten to overwhelm government finances over the medium-term.
Thursday, 21 April 2011
Those who live by the bond yield ...
Michael Taft: Remember all those comments in the days following the latest bank-bailout? How the markets had sent positive signals? That confidence was slowly rebuilding. 2-year yields fell from their high of 10.25 percent on March 3rd to 8.65 percent on April 13th. 10-year yields fell from 10.22 percent to 9.09 percent. Okay, far away from being able to re-enter the market – but evidence that the Government’s banking policy was gaining something approximating market credibility.
Well, say good-bye (for now) to all that.
In just a week all those gains have been wiped away and the slide continues. As of lunchtime today, 2-year yields have set a new high – at 10.35, while 10-year yields rose to 10.31 percent.
Where are the analysts now? Where are the kudos? What has gone wrong – apart from the fact that drawing even tentative conclusions from such a short time-frame is bound to disappoint?
This is all part of a continuing crisis in the Eurozone periphery. Even the assertions that Spain had effectively ‘de-coupled’ from the periphery with strengthening bond yields are being tested by the markets. Rising yields and falling investor demand is re-starting the worries. Greece and Portugal continue to slide as well.
It is long past time that policy-makes – here in Ireland or especially in the Eurozone – stop seeing this as a sovereign debt crisis and admit that this is a bank crisis, spreading contagion wherever it goes.
As Yanis Varoufakis puts it: ‘It’s the (German) banks, stupid’.
Well, say good-bye (for now) to all that.
In just a week all those gains have been wiped away and the slide continues. As of lunchtime today, 2-year yields have set a new high – at 10.35, while 10-year yields rose to 10.31 percent.
Where are the analysts now? Where are the kudos? What has gone wrong – apart from the fact that drawing even tentative conclusions from such a short time-frame is bound to disappoint?
This is all part of a continuing crisis in the Eurozone periphery. Even the assertions that Spain had effectively ‘de-coupled’ from the periphery with strengthening bond yields are being tested by the markets. Rising yields and falling investor demand is re-starting the worries. Greece and Portugal continue to slide as well.
It is long past time that policy-makes – here in Ireland or especially in the Eurozone – stop seeing this as a sovereign debt crisis and admit that this is a bank crisis, spreading contagion wherever it goes.
As Yanis Varoufakis puts it: ‘It’s the (German) banks, stupid’.
Monday, 29 November 2010
Ireland, bond markets and democracy
"Making the “market” the actor abstracts from the real world of speculators and financial fraud. It facilitates the mythology that the dysfunctional financial system is not the work of men and women (mostly the former) within institutions with socially irrational rules and norms, but a manifestation of the inexorable operation of the laws of nature that no government can change. This objectification is ideology: it is not “markets” that seek socially devastating budget reductions in Ireland, Greece and elsewhere, but a specific collection of financial speculators whose anti-social behaviour is possible because governments removed regulations of capital markets". You can read the rest of John Weeks' post on Social Europe Journal here.
Friday, 12 November 2010
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.
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.
Friday, 5 November 2010
2011, 2014, the Bond Markets and Growth
Nat O'Connor: It seems to me that there is some confusion in the way in which international factors on Ireland's deficit are presented to the general public in the media. In particular, the 'requirement' that Ireland's deficit is reduced to three per cent of GDP by 2014 seems to be confused with the issue of whether it may be too expensive for us to borrow from the bond markets early next year. The financial institutions that lend money to countries (i.e. the 'bond markets') do not care whether Ireland reaches three per cent of GDP by 2014, provided we can show evidence of an ability to repay our borrowings. But in terms of providing this evidence, the deadline for satisfying these lenders may well be early 2011, not end-2014.
Those who are offering to lend money to Ireland at the moment (at high rates of nearly eight per cent) are taking a chance on making big money on these loans; balanced against a heightened risk that this or the next Irish Government will decide not to pay back the loan - or only pay back a portion of it. However, they are not crazy. They would not lend to Ireland (except at extortionate, short-term rates) if they thought that it was highly likely that we would default on the loans. So, we are still in a position where some of these large - and coldly calculating - financial institutions think that they can make money. (That is, they are confident that we will pay back the loans, or at least enough years of interest, to make it worth their while taking the risk). Unfortunately, not enough of them are interested in lending to Ireland, hence we would have to borrow at nearly eight per cent from the small pool of risk-takers who are willing to lend.
However, the institutions that might consider lending to Ireland at lower rates are not necessarily the same financial institutions that would lend at higher rates. Some institutions make more conservative lending decisions, while others go for more risky investments. This is an oversimplification, perhaps, as most will have balanced portfolios, but it hopefully illustrates the point that not all participants in the international bond markets are clones.
The more conservative institutions operating in the bond markets want to see more evidence of ability to pay. That is, they want evidence that Ireland has moved into a period of economic growth that can be sustained. And they want evidence that tax revenue is stable. And they certainly want to see public expenditure reduced over time to what the state can afford, based on its revenue. However, as long as there is evidence that the state is on a sustainable path, it doesn't matter whether it is 2014, 2016 or 2020. All that matters is that Ireland is on a stable growth trajectory and can show that it will be able to pay back the money.
Meanwhile, there is another part of the bond market that Ireland must also satisfy. That is those institutions that have already - in better times - lent money to Ireland. (Much of our borrowing is at 3 or 4 per cent interest). Like the conservative financial institutions that will not currently lend to Ireland, those who have already lent to us very urgently want to see evidence of ability to pay! They want to see a credible growth plan, because they are not even benefitting from especially high interest rates on what have become risky loans. Some of these institutions may be the same ones that might lend more money to Ireland in future, but only if presented with evidence of growth.
Finally, there is the EU dimension to all of this. The EU Stability and Growth Pact is a political agreement made between all Eurozone countries. Our Government have pledged to return our deficit to 3 per cent by 2014. This is a political decision. It was perhaps a necessary decision in order to persuade the European Central Bank to assist Ireland by buying some of our bonds, and accepting the IOUs we gave our banks to cash in. But it is only one of the many political compromises we make in Europe all of the time. Much EU business is done by consensus within the Council of Ministers. There is certainly scope for Ireland to gain compromise on this target, with the support of other Eurozone countries who are also in danger of missing the target.
However - and this is where the more immediate bond market question gets mixed up with the EU 2014 question - if we think that our economic strategies are not going to deliver growth, and therefore the international bond markets will not lend to us at a reasonable rate, we have to remain on reasonably good terms with the ECB, so that they will buy our bonds and, ultimately, bail us out with the EU-IMF fund, if the worst comes to pass.
Ironically, the effort to satisfy the EU by aiming for a deficit of 3 per cent by 2014 - in case we need EU help - is likely to make it more likely that we will need to avail of emergency assistance! That is because our sequence of severely contractionary budgets (and a further €6 billion in cuts and taxes planned for December) is shrinking the economy, cutting or even killing growth, and making it less likely that the more risk-averse parts of the bond market will lend to us.
How do we get out of this bind? The answer is simply that we need to deal with 2011 before we deal with 2014. The issue in 2011 is whether Ireland has a credible growth strategy, which will persuade more international lenders to lend us money at a more reasonable rate. The only way that this can be achieved is by a smart combination of tax changes, expenditure changes and measures to foster growth and jobs.
Crucially, Budget 2011 is effectively Ireland's last chance to change direction. The Government has the option of spending sufficient money from the national pensions reserve fund (NPRF) to offset some - or maybe even all - of the contractionary effects of increased taxation and reduced expenditure in 2011. We do still need to lower the deficit by a combination of tax and spending changes. But we also need to boost jobs, boost aggregate demand, and boost economic growth.
At this stage, a number of commentators have made the same observation and a range of bodies have put forward credible options for boosting growth in the economy. Without getting into the pros and cons of the different approaches - and there are profound differences - there are many options that Government could take:
- TASC proposes a €3 billion Economic Recovery Fund in 2011 including a credit guarantee scheme for small businesses and rollout of next generation broadband (which would be labour intensive);
-ICTU calls for a minimum investment of €2 billion per annum, over three years, to be spent on a new water and waste network, retrofitting energy inefficient buildings, educational buildings and broadband (with options to bring in private finance, as well as using NPRF money);
- Fine Gael propose a major state-led investment of €18 billion through their NewERA proposals, funded through selling state assets;
- Labour wants to create a Strategic Investment Bank to invest €2 billion (initially) in SMEs and raise finance for infrastructure;
- Sinn Féin proposes a 3.5 year stimulus, using €7 billion from the NPRF (€2 billion in 2011) to invest in a revised National Development Plan, including remediating the water network, extending and rolling out broadband. Also a 'cash stimulus' through welfare, which would boost aggregate demand in local areas;
- IBEC have stated that only growth will solve the fiscal crisis. They call for limiting cuts to capital investment, reviews to ensure all new government policy and legislative initiatives support employment, a radical overhaul of the public employment service, an ambitious national internship programme and the continued PRSI reduction for employing people who are long-term employed;
- ISME "warns of Government complacency on jobs". They claim that businesses are "handicapped by a reduction in consumer demand exacerbated by exorbitant costs, late payments and a difficulty in accessing bank credit";
There is a broad and growing consensus on the economy. That consensus is on the need to change direction, and focus on jobs and growth.
And this is recognised internationally. Paul Krugman notes the 'experiment' (and here also) that Ireland's austerity resulted in a worse result than Spain's attempts at stimulus. Joseph Stiglitz has claimed that Europe "made a wrong bet with austerity". In particular, Ireland’s struggle to revitalize its economy after the country’s worst recession on record shows the risks of focusing on deficits. "The belief that markets will get new confidence has been shown wrong" by Ireland’s austerity drive, Stiglitz said.
If the Government continues to monomaniacally focus on cuts and taxes, and refuse to present a credible growth strategy, it will bring us much closer to requiring an EU-IMF bailout, allow further collapse in the economy and cause unnecessary hardship for many people.
Those who are offering to lend money to Ireland at the moment (at high rates of nearly eight per cent) are taking a chance on making big money on these loans; balanced against a heightened risk that this or the next Irish Government will decide not to pay back the loan - or only pay back a portion of it. However, they are not crazy. They would not lend to Ireland (except at extortionate, short-term rates) if they thought that it was highly likely that we would default on the loans. So, we are still in a position where some of these large - and coldly calculating - financial institutions think that they can make money. (That is, they are confident that we will pay back the loans, or at least enough years of interest, to make it worth their while taking the risk). Unfortunately, not enough of them are interested in lending to Ireland, hence we would have to borrow at nearly eight per cent from the small pool of risk-takers who are willing to lend.
However, the institutions that might consider lending to Ireland at lower rates are not necessarily the same financial institutions that would lend at higher rates. Some institutions make more conservative lending decisions, while others go for more risky investments. This is an oversimplification, perhaps, as most will have balanced portfolios, but it hopefully illustrates the point that not all participants in the international bond markets are clones.
The more conservative institutions operating in the bond markets want to see more evidence of ability to pay. That is, they want evidence that Ireland has moved into a period of economic growth that can be sustained. And they want evidence that tax revenue is stable. And they certainly want to see public expenditure reduced over time to what the state can afford, based on its revenue. However, as long as there is evidence that the state is on a sustainable path, it doesn't matter whether it is 2014, 2016 or 2020. All that matters is that Ireland is on a stable growth trajectory and can show that it will be able to pay back the money.
Meanwhile, there is another part of the bond market that Ireland must also satisfy. That is those institutions that have already - in better times - lent money to Ireland. (Much of our borrowing is at 3 or 4 per cent interest). Like the conservative financial institutions that will not currently lend to Ireland, those who have already lent to us very urgently want to see evidence of ability to pay! They want to see a credible growth plan, because they are not even benefitting from especially high interest rates on what have become risky loans. Some of these institutions may be the same ones that might lend more money to Ireland in future, but only if presented with evidence of growth.
Finally, there is the EU dimension to all of this. The EU Stability and Growth Pact is a political agreement made between all Eurozone countries. Our Government have pledged to return our deficit to 3 per cent by 2014. This is a political decision. It was perhaps a necessary decision in order to persuade the European Central Bank to assist Ireland by buying some of our bonds, and accepting the IOUs we gave our banks to cash in. But it is only one of the many political compromises we make in Europe all of the time. Much EU business is done by consensus within the Council of Ministers. There is certainly scope for Ireland to gain compromise on this target, with the support of other Eurozone countries who are also in danger of missing the target.
However - and this is where the more immediate bond market question gets mixed up with the EU 2014 question - if we think that our economic strategies are not going to deliver growth, and therefore the international bond markets will not lend to us at a reasonable rate, we have to remain on reasonably good terms with the ECB, so that they will buy our bonds and, ultimately, bail us out with the EU-IMF fund, if the worst comes to pass.
Ironically, the effort to satisfy the EU by aiming for a deficit of 3 per cent by 2014 - in case we need EU help - is likely to make it more likely that we will need to avail of emergency assistance! That is because our sequence of severely contractionary budgets (and a further €6 billion in cuts and taxes planned for December) is shrinking the economy, cutting or even killing growth, and making it less likely that the more risk-averse parts of the bond market will lend to us.
How do we get out of this bind? The answer is simply that we need to deal with 2011 before we deal with 2014. The issue in 2011 is whether Ireland has a credible growth strategy, which will persuade more international lenders to lend us money at a more reasonable rate. The only way that this can be achieved is by a smart combination of tax changes, expenditure changes and measures to foster growth and jobs.
Crucially, Budget 2011 is effectively Ireland's last chance to change direction. The Government has the option of spending sufficient money from the national pensions reserve fund (NPRF) to offset some - or maybe even all - of the contractionary effects of increased taxation and reduced expenditure in 2011. We do still need to lower the deficit by a combination of tax and spending changes. But we also need to boost jobs, boost aggregate demand, and boost economic growth.
At this stage, a number of commentators have made the same observation and a range of bodies have put forward credible options for boosting growth in the economy. Without getting into the pros and cons of the different approaches - and there are profound differences - there are many options that Government could take:
- TASC proposes a €3 billion Economic Recovery Fund in 2011 including a credit guarantee scheme for small businesses and rollout of next generation broadband (which would be labour intensive);
-ICTU calls for a minimum investment of €2 billion per annum, over three years, to be spent on a new water and waste network, retrofitting energy inefficient buildings, educational buildings and broadband (with options to bring in private finance, as well as using NPRF money);
- Fine Gael propose a major state-led investment of €18 billion through their NewERA proposals, funded through selling state assets;
- Labour wants to create a Strategic Investment Bank to invest €2 billion (initially) in SMEs and raise finance for infrastructure;
- Sinn Féin proposes a 3.5 year stimulus, using €7 billion from the NPRF (€2 billion in 2011) to invest in a revised National Development Plan, including remediating the water network, extending and rolling out broadband. Also a 'cash stimulus' through welfare, which would boost aggregate demand in local areas;
- IBEC have stated that only growth will solve the fiscal crisis. They call for limiting cuts to capital investment, reviews to ensure all new government policy and legislative initiatives support employment, a radical overhaul of the public employment service, an ambitious national internship programme and the continued PRSI reduction for employing people who are long-term employed;
- ISME "warns of Government complacency on jobs". They claim that businesses are "handicapped by a reduction in consumer demand exacerbated by exorbitant costs, late payments and a difficulty in accessing bank credit";
There is a broad and growing consensus on the economy. That consensus is on the need to change direction, and focus on jobs and growth.
And this is recognised internationally. Paul Krugman notes the 'experiment' (and here also) that Ireland's austerity resulted in a worse result than Spain's attempts at stimulus. Joseph Stiglitz has claimed that Europe "made a wrong bet with austerity". In particular, Ireland’s struggle to revitalize its economy after the country’s worst recession on record shows the risks of focusing on deficits. "The belief that markets will get new confidence has been shown wrong" by Ireland’s austerity drive, Stiglitz said.
If the Government continues to monomaniacally focus on cuts and taxes, and refuse to present a credible growth strategy, it will bring us much closer to requiring an EU-IMF bailout, allow further collapse in the economy and cause unnecessary hardship for many people.
Subscribe to:
Posts (Atom)