2012-07-24 – London
US treasuries and German bunds are at historically low yields. Bonds with shorter maturities are even reaching negative nominal rates and negative real rates through most of the yield curve. Conversely, however, credit default swaps on these issues have been constantly increasing, reflecting the view that they represent a rising risk. This is contradictory. If they are so risky, why are the yields so low?
The simplest answer is either that some market participants still consider US treasuries and German bunds to be risk-free or central bank intervention is affecting their price.
According to a study performed by Fulcrum Asset Management, government bonds retain their “safe” status when credit default swaps are below 200 basis points. That’s part of it. Importantly, though, they are being strongly affected by the very expansive monetary policy that is being implemented by central bankers. In essence, the central banks are buying their own governments’ bonds, thus driving down the yields that need to be offered, even though the wider market regards their risk levels to warrant higher yields. They’re artificially depressing the price and disguising the real riskiness of the sovereigns.
Ingenious or foolhardy
The purchase of government securities enables central banks to carry out open market operations, control short term interest rates and the supply of base money in their economies. In short, they can indirectly control the whole money supply. This keeps the rates at which government can borrow low, but also displaces the sector’s main traditional buyers – pensions and insurance companies. And these players are starting to confront central bankers. In their opinion, the activism of central banks without fiscal consolidation will only alter the functioning of markets, contaminate price discovery and distort capital allocation.
Despite the depressed sovereign debt yields, in the view of some, credit risk embedded in both US and German sovereign debt issues has been escalating, as shown by credit default swap evolution and by rating downgrades. Credit default swaps on US 10 year sovereign bonds have increased to 47bps, while credit default swaps on German issues have increased to 76bps. Credit rating agencies have been warning about – and effectively downgrading – the credit rating of these sovereigns. The most recent warning was issued today by Moody’s, which has lowered its outlook for Germany from stable to negative. It argues that the increased likelihood of a Greek exit from the single currency and the need for greater financial support for struggling Euro-zone countries will weigh negatively on Germany’s public finances. However, it is widely believed by market participants that credit default swaps overstate default risk. The credibility of the rating agencies, moreover, has been eroded significantly.
This anomaly will be solved in the coming months, as negative real interest rates are unsustainable for investors. Intervention by central banks, moreover, cannot last indefinitely. It may be suitable for solving temporary liquidity crises but cannot solve underlying solvency problems. Furthermore, the European Sovereign debt crisis should have a final outcome in the coming months. Spain, which is too big to save, is approaching an outright default. A final and long-term solution must be designed to avoid a financial catastrophe. Lastly, a clearer road-map to track US fiscal deficit should be implemented after presidential elections in October.
The uncertainty regarding economic growth will be steadily reduced and central bankers and investors will start to sell their sovereign bond holdings. Alternatively, the credit risk embedded in these sovereign issues will be reflected on their yields and we will move towards a financial world without risk-free assets.
