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Government bond returns and “back door” QE policy

Journalists and financial commentators have been kept very busy this year. Market participants and investors have clamoured for information on debt ceilings, credit ratings, and restructurings. 2011 looks like a year that will go down in history as one of the most volatile on record.

With that in mind, I thought it might be useful to focus on the actual returns within government bond markets over the course of the year. The below chart represents the total return of a 7-10 year bond index compiled by Bloomberg/EFFAS in local currency terms.

Government bond 7-10yr returns - YTD

We found this analysis very interesting. Looking at the member nations of the EU, the German government bond market has been the top performer with a 10.0% return, followed by Ireland and Austria with 9.1% and 7.4% respectively. Investors in Italian government bonds have made 1.0% , despite a widening in Italian 5 year CDS from 240 to 450 basis points (currently equating to a 30% probability of a default event occurring in the next 5 years).

There are a couple of factors at play here.

Firstly, all returns are local currency. Government bond yields are major drivers of currency, so the above chart could be capturing currency strength or weakness. In order to account for the currency impact, I have re-based the returns to the world’s reserve currency – the US dollar.

USD weakness has been a major theme this year

We now get a clear picture of a) the US dollar weakness versus most major currencies this year and b) the impact that an increase in risk aversion will have on the returns for government bonds. Clearly, Switzerland and Norway have benefitted from solid appetite for government debt and strengthening currencies versus the USD. Time will tell whether the Swiss National Bank’s intervention in currency markets will be able to be maintained without inflation becoming a concern for the SNB. Though there might be an easier way for the Swiss to benefit from a weak currency – join the euro.

Secondly, European bonds have performed very strongly this year, despite concerns over the ability of governments to fund themselves in capital markets. These returns show that Germany remains a safe haven of choice, despite concerns that it will have to backstop weaker peripheral European nations. This has resulted in Bund yields collapsing, and peripheral European sovereign bonds have benefitted from this (as they are priced off “risk-free” bunds, in a similar way that corporates are). Spreads on peripheral sovereign debt are wide, but absolute yields have fallen.

Finally, there is a big elephant in the room, and Jean-Claude Trichet is riding it. The ECB, through its Securities Markets Programme, spent €13.3bn on sovereign bond purchases last week which brought its total holding of Eurozone government bonds to €188.6bn. Having such a large buyer in the market is obviously keeping yields on European government debt lower than equilibrium levels. The big question that we are trying to digest is just how governments and policymakers can stimulate their economies without further extraordinary monetary policy measures. It looks to us like this has been a jobless recovery, consumers are hiding, and stimulatory fiscal policy can be ruled out due to heavily indebted governments.

Mike referred to QE3 in an earlier blog, and we are starting to think that the odds we might see QE10 in the US are rising. Top of the agenda at the Bank of England’s MPC meeting will be whether it should deploy more QE. As for the ECB, it may well be forced to provide “enhanced credit support” (also known as “backdoor QE” here on the M&G bond desk) for the remainder of 2011.


Is the Bank of England the most profitable company in the world?

Well the answer is probably no.  Exxon Mobil for example made $19 bn last year, and its profits were over $40 bn in 2007.  We can also debate whether the Bank of England is a company anyway (it says so on the bank notes, but it was nationalised in 1946).

However, with gilt yields continuing their march downward we thought it would be interesting to put an estimate on the returns the Bank of England has generated in the 2 1/2 years following the start of Quantitative Easing (QE). In my back of an envelope analysis I’ve calculated that the Bank is currently sitting on a profit in the region of £32 bn. On an initial outlay of £198 bn, this represents a return of about 16% (roughly 40/60 split between capital gain and income).  On an initial outlay of £198 bn of freshly printed fivers (costs = paper, ink) the return is even better of course.  The highest yield that the Bank bought gilts at was 4.62% on 17 July 2009 (some 4.75% 2030s).  That was a price of 101.79, compared with 119.53 today.

Clearly the caveat here is that if the bank actually tried to realise this profit I’m pretty sure that 10yr Gilt yields would be significantly higher than 2.3%, where they stood this morning.  With more poor UK data out this morning (PMI Services survey only just above the magic 50 mark), the market’s rally today can be at least partly explained by expectations of more QE – there’s an MPC meeting on Thursday, but most expect any announcement to come with the publication of the Inflation Report in November (the usual forum for big policy changes).  Whether gilt purchases are an efficient means of monetary stimulus or not is something we can save for another blog…


Ireland (austerity) vs Iceland (default) – who’s winning? And a Twitter update…

Back in March we wrote about Iceland’s response to the banking crisis, and how it differed to other countries that stepped in to support their banking systems. This week, Paul Krugman commented about Iceland’s exit from its IMF programme.  The IMF has declared that programme successful, and Krugman claims that Iceland is back in the capital markets and has its “society intact”.  He puts this success down to three things – debt repudiation (default), capital controls and currency depreciation.  In fact the opposite of the approach that the distressed Eurozone economies are forced to endure.

Krugman acknowledges that Iceland has a way to go – unemployment is nearer 7% than the 1% it stood at before the crisis.  But is default a better option than austerity and an overly hard currency?

Well we have a control of sorts for this experiment. Another member of Alex Salmond’s Arc of Prosperity, Ireland is taking the other path.  Having borrowed EUR 67.5 billion from the EU and the IMF in 2010, Ireland committed to an aggressive austerity package, and far from defaulting, the government explicitly guaranteed the debts of its broken banking system.  The 4 year austerity plan raised sales tax, cut government spending and reduced the minimum wage, with a plan to get the deficit below 3% of GDP by 2014.  Is that working?

Well we’ve just seen quarterly GDP growth of 1.9%, the highest rate since the end of 2007 (most quarters since then have been negative), although unemployment remains around the 14% level, and I guess the best you could say is that it’s no longer rising.  Stronger exports have helped – domestic weakness persists.  One measure that has improved dramatically as the result of the austerity programme has been Ireland’s borrowing costs.  Since mid July, the longest dated Irish government bond has fallen in yield from 12.5% to under 8.5%, making this one of the best performing bond markets in the world – and in sharp contrast to Spanish and Italian bonds over that period.

It will be interesting to see which approach to national indebtedness proves most successful over the longer term – I’ve always said that I thought that an early default against bondholders by the peripheral Europeans was the best outcome for those populations.  It’s almost certainly what the populations would vote for, if, like the Icelandics, they were offered the choice.  Credit rating versus a job for your kids?  No contest.  As George Osborne follows the austerity path for the UK in defence of its AAA rating (now lost by the US, which then saw one of biggest ever monthly rallies in its bonds), we’re also part of these experiments.

A while ago I wrote about the lack of protest songs from the youth of today.  Turns out there were other ways of protesting about being a NEET (not in employment, education or training) than singing, but here’s a link to a huge list of 1980s protest songs.  Also a link to a Billy Bragg article on a similar theme.

Finally a reminder about our new Twitter feed, @bondvigilantes.  We’ve been going for a couple of weeks now, and as well as linking to this blog, we’ve tweeted our views throughout the day of the US AAA downgrade, and on our not very widely held assertion that Alistair Darling had a “good” credit crisis.  We also tweeted a link to the new and utterly crucial remastered and complete Smiths box set.  Join us, join us.


The US and Eurozone economies are probably now shrinking

Yesterday’s Philly Fed number was an absolute shocker. The Philadelphia Fed’s general economic index is something we watch closely because it is a good indicator of the Institute for Supply Management indices, and the ISM surveys are arguably the most important monthly US economic data releases.

We wrote a comment back in January 2008 about the importance of the Philly Fed data release, which back in 2008 was already flashing red. Yesterday’s release was a staggering minus 30.7 (versus expectations of +2, nice work economists), and as the chart below demonstrates, these kind of levels give a strong indication that a negative US GDP print is coming.

Philly Fed number suggests negative GDP growthMeanwhile, Eurozone economic data has followed the US in falling off a cliff. It was announced on Tuesday that the Euro area economy grew at just 0.2% quarter on quarter in Q2, with the big worry being that the preliminary growth estimate for the German economic powerhouse was a puny +0.1% versus expectations of +0.5%. More worrying still is that economic conditions appear to have deteriorated significantly since the end of Q2, raising the very real chance that the data for Q3 will be negative.

We’ve written a lot about the ECB recently, and have been utterly flummoxed by the quite outrageous decision to hike rates twice this year (eg see here). In July 2008, when the ECB had its last major policy disaster, it took three months for the ECB to reverse the decision to hike and start cutting rates. It’s starting to feel like Groundhog Day.

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Buffett, taxation and the collapse in the average male worker’s standard of living

On Monday Warren Buffett stated “our leaders have asked for ‘shared sacrifice’”.  But when they did the asking, they spared me….whilst most Americans struggle to make ends meet, we mega-rich continue to get our extraordinary tax breaks.” (click here for the NY Times op-ed).

We’d just been looking at the chart below, so the timing of his commentary was good.  Whilst mean US male weekly earnings are up 13% in inflation adjusted terms since 1969, this is highly skewed by high earners getting a disproportionate share of the economic gains of capitalism (and government intervention in capitalism!).  The median, which measures the middle person in the distribution, has actually fallen by 28% over the same period.  At the same time full time employment has fallen by 16.5% for men.

This lack of burden share is also well illustrated by Stephen von Worley’s breakdown of the relative U.S. income tax burden over time. Three observations are striking in this context. First, the tax burden was comparatively high in the 1950s and 1960s when the U.S. public debt stayed flat at relatively low levels. Secondly, the Bush administration lowered the tax burden across income levels at a time when the federal debt level had already been at historically high levels. We know how the story has continued. Finally, Buffett and his peers benefitted disproportionately from the Bush administration’s fiscal policy.

Interestingly, Jim tore out this newspaper article from the New York Post last time he was in the States.  The commentator, Bill O’Reilly is famously right wing, and tries to avoid the real, and obvious conclusions of the survey – whilst it’s true that 49% said “no” to the question “do you think our government should redistribute wealth by heavy taxes on the rich?” (a fairly biased question to start with), 47% said “yes, heavy taxes please”.  It makes the Republican’s refusal to even consider tax rises as part of the disastrous debt ceiling negotiations look not just suicidal from a credit rating standpoint, but even undemocratic.


Sell off in high yield markets provides a buying opportunity

The price action in the high yield market has been brutal over the last few weeks. A very respectable year-to-date return of 3.8% as at end of June currently stands at -1.3% (according to the Merrill Lynch European Currency HY Index as at 15/08/11). That’s a significant re-pricing of risk. To put it in context, look at the iTraxx Europe Xover Index (for an explanation, see here). The most liquid vehicle in European high yield has seen spreads almost double from 350 in May to 595 today, and around 650 late last week. In other words, investors now require almost double the compensation for investing in the same 40 high yield names from three months ago.

Concerns around a stalling economic recovery & sovereign fears have seen investors redeem money in record amounts, forcing unprepared investors to sell indiscriminately into a very nervous buyer base. We’ve seen this sort of price action before – back in 2009, and it created some superb buying opportunities. Around $3bn of outflows were recorded in the US during the week to Aug 10th 2011, with the figure estimated to be around €600m in Europe (see here). These are near record outflows respectively. Again taking the Xover Index as a proxy, the market is pricing in a default probability of some 42% (assuming a 40% recovery).  Whilst this is some way shy of what the same index was pricing in at the nadir of the crisis, excluding CCC grade bonds, it is still pricing in a higher default rate than anything experienced in any five year period since 1970s.

Now I’d be a fool to call the bottom of the market here. If the global economy double dips, spreads will undoubtedly go wider again.  Yet I am convinced that there are some bargains on offer. As James talked about in his recent blog, good old fashioned credit analysis is key. Where I can lend to sensibly capitalised businesses – with decent earnings prospects, strong liquidity, limited re-financing risk and good  investor protection in the form of comprehensive covenants – I remain inclined to continue to do so. In a world where we expect interest rates to remain lower for longer, the 8-12% yields on offer from investing in senior secured paper issued by certain packaging and cable companies looks particularly attractive.


Oil prices and the impact on inflation linked bonds

With a significant fall in the oil price (-28% since the end of April), inflation linked bonds are underperforming their nominal counterparts. The biggest impact though is in the US market, where TIPS yields have risen, especially at the shorter maturities. This chart shows that whilst short dated index linked gilt yields have edged up in the last couple of weeks, the yield on the 2012 maturity TIPS has risen aggressively.

Short dated TIPS are very geared to the oil price

Why are oil prices (both rising and falling) much more important for US inflation linked bonds than they are for those in the UK and Europe? It’s all about tax. In the UK, the duty rate for road fuel is the equivalent of £2.20 per US gallon, and VAT at 20% is charged on top of both the fuel and the duty. European taxes are similarly high (the Netherlands is especially high). In the US, federal tax is just 18.4 cents per gallon – adding in other state taxes, the average is 48.1 cents per gallon. So UK fuel taxes including VAT are about 10 times higher than those in the US. As a result, a rise or fall in the crude oil price impacts a much, much bigger part of the cost of a gallon of gasoline in the US than elsewhere, and therefore there is a more significant impact on the CPI as a result (both directly in the fuel element, and then subsequently through pass through costs to delivery drivers etc.).

This chart shows the impact of oil prices rising up to $180 per barrel and shows the impact on UK, EU and US inflation rates. All other things being equal, a rise to $180 would add 1.43% to the UK RPI, 1.54% to EU CPI and a massive 4.88% to US CPI. So higher tax rates protect UK and EU consumers against inflation and inflation volatility – not sure they’d see it like that though…

Oil Shocks - Effect on inflation measures of an oil price increase

Anyway, elsewhere, I read a review of a BBC2 Horizon programme called Do You See What I See? It looked at sporting results for teams that play in red and blue – there’s always been an argument that teams in red do disproportionately well – this looked at a study from the 2004 Olympics, where taekwondo results were analysed. In that sport, red and blue combat gear is assigned at random – yet the results showed that red won 2/3rds of the results. Better still, when the fights were filmed, and the colours reversed digitally, judges watching the recordings still awarded of the “red” fighters the bouts. Fascinating stuff – and congratulations Nottingham Forest (in red) on a stunning cup come back last night versus Notts County!


US downgrade and ECB bond buying: conference call replay details

Yesterday Jim did a conference call covering both the S&P downgrade of the US sovereign credit rating and the ECB’s massive buying of Spanish and Italian government bonds.

You can listen to a recording of the call and view the slides by clicking here.


What is risk off?

Recent selling of risk assets into traditional haven government bonds has taken their yields back near their all time lows. Will people continue to buy them in a risk off trade? We are almost certainly nearer the beginning than the end of a western world sovereign debt crisis. That means quite clearly that Gilts, Bunds and Treasuries are not the ‘risk free’ investments they once were. In relative terms, their risks are low and perhaps falling. But in absolute terms, their risks are high and rising. The US was just downgraded from AAA by S&P, and yet their yields are still rallying, contrary to the expectations of many and contrary to traditional theory. If greater fiscal union is the final solution to the peripheral European sovereign debt crisis, then the transfer of wealth from Germany and other strong EU states to the weaker ones will see Bunds, amongst others, sell off dramatically. Yet if fiscal union is unacceptable to some EU states and it fails to get parliamentary approval, then surely Bunds will remain firmly within the very top echelon of government bonds in the world, with yields potentially less than 1%? Perhaps the austerity plan which has been so important in supporting Gilt yields and the AAA rating in recent times sees UK borrowings become the last true safe haven in the Western world? Yet the low economic growth consequences of this approach could also scupper the plans and have just the opposite effect. As you can see, in each case traditional economic views and expectations about these ‘risk free’ safe havens could prevail, or could be utterly wrong. That doesn’t sound to me to be very risk free at all!

So, to where do we retreat in a new paradigm in which traditional safe havens are no longer such? Given the recent widening in credit spreads, I believe that some of the high quality investment grade credit now looks good value again. Maybe, just maybe, the new safe haven could become the high quality, low beta, internationally exposed, lowly geared, corporate bond universe?


The economy continues to lead credit

Two months ago I questioned whether the decoupling between credit spreads and economic fundamentals could continue for much longer. I felt at the time that at some stage the weakening economic data would start to drag credit spreads wider, at least relative to government bonds. I also asked whether we might enter an environment in which high quality investment grade credit could see a flight to quality rally, whilst some of the lower quality, higher beta credit could sell off. Let’s see how government bonds and credit have fared since this blog was posted.

Bunds, Gilts and Treasuries have had a fantastic couple of months as shown in the chart below, with 10 year benchmark returns of 7%, 5.25% and 5%, respectively. However, this did not happen solely because economic data turned so horribly south, although it clearly did. These government bonds were boosted because of the peripheral sovereign debt concerns in Europe, and debt ceiling negotiations almost bringing about a technical default in the US. The markets panicked and sold risk and bought traditional, relative safe havens.

It’s been a great couple of months for treasuries, bunds and gilts

How has credit performed over the same period? The broad European, Sterling and US investment grade indices’ spreads have widened over the last two months. European spreads have risen from an average of +143 basis points to +172 (20% spread widening), Sterling spreads have risen from +193 to +218 basis points (13% spread widening), and US spreads have risen from +162 to +173 basis points (7% spread widening). Credit default swap spreads paint a similar picture of rising credit premia and rising risk aversion in the last two months, although the extent of the credit spread sell off has been greater in this market than in cash, largely due to far superior liquidity and therefore activity. The index of the 125 investment grade names in Europe has risen from a weighted average spread of 104 to 134.5, or a 29% spread widening, and the equivalent US index has risen from 96 basis points to 105 basis points, a widening in spreads of 9%.

Market participants in all risk assets have reacted typically: selling higher risk assets for perceived lower risk ones. In fixed income, we have observed this both in the cash market and in the CDS market.

Riskier corporate bond spreads have widened

The CDS market has also widened

However, in June I expected to see this as a result of a fundamental worsening in the economic data and environment, rather than as a result of a global panic in risk that has actually transpired. But the panic sell off in all types of risk has seen all sorts of participants sell whatever they can and buy anything traditionally perceived as risk free. Assets of all classes have been sold into higher quality government bonds.

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