Please note the content on this website is for Investment Professionals only and should be shared responsibly. No other persons should rely on the information contained within this website.
Logo of Bond Vigilantes
Tuesday 19 March 2024

Just as the ECB has started tightening monetary policy, and just as the sovereign debt crisis appears to be coming to a head (don’t rule out a Greek restructuring over this long weekend although it remains an outside chance), it feels like we might have seen the best of German growth for this cycle.

The chart below (from UniCredit via Bloomberg) shows that cargo volumes at Frankfurt Airport have fallen substantially from their peak, and are now down year on year.  This series has been a good lead indicator for export growth (which was running at a stunning 18.5% in 2010), which itself was a big driver for Germany’s above trend GDP growth rate of 3.6% last year.

German exports look likely to fall

 

 

Fraport, the airport operator, has said that the disruption to the global supply chain following the Japan earthquake was to blame for the volume falls – but the drop also coincides with a period of a considerable strengthening of the Euro.  On a trade weighted basis the currency is up over 7% from its low in January.

Euro has strengthened considerably

 

I’ve seen research recently that’s claimed that Germany, with a “high margin big ticket” exporting focus is less impacted by a strengthening currency than, say, Portugal which exports lower value added, low margin goods (e.g. leather bags) – if that is the case the periphery must be really suffering with the Euro strength.

This morning we had a second monthly fall in German business confidence (the IFO index), although the outright level is still relatively strong.  Nevertheless, whilst the ECB rhetoric is about inflation fighting and tighter monetary policy, the Euro can stay strong – and that’s going to hurt Germany.

Yesterday I attended a lunch with two senior IMF officials (hosted by Morgan Stanley), which came on the back of a number of excellent recent publications from the Fund (the speakers drew heavily from the Global Financial Stability Report, but it’s also worth having a look at the World Economic Outlook and Fiscal Monitor).

Financial stability has generally improved over the last half year, but numerous vulnerabilities and challenges remain.  The biggest medium term risk for developed countries was deemed to be the fiscal situation in the US and Japan.  The US in particular is showing little appetite to reduce fiscal deficits or government debt levels.  US gross government debt levels are approaching a concerning 100%, about 43% of what the US government spends is financed by borrowing, and yet the political parties are struggling to agree on the right course of government action.  Special interest groups are having more and more political power, making it harder to increase taxes or reduce government spending.  A build up in public debt means that the US and Japan are becoming increasingly vulnerable to a rate shock, with the US having an average debt funding cost approaching 10% of tax revenue, a level that Moody’s have previously suggested puts the US credit rating at risk.  As debt levels increase, the danger is that it requires a smaller and smaller increase in bond yields before debt interest costs hit 20% of tax revenues (in the US this is when the average borrowing cost is above 6%, but in Japan this has fallen to a little over 4%).  The US is driving closer and closer to the cliff edge, testing when investor confidence is going to break.

One of the biggest short terms risks is unsurprisingly the Eurozone debt crisis, where funding costs need to be reduced and more clarity needed on EFSF/ESM support and the debt restructuring mechanism.  This is especially urgent given that the political will for further austerity and bailouts is likely to wane, with current elections in Finland an interesting barometer.  In terms of the likelihood of sovereign debt restructuring, an interesting discussion point around the table was that if the market starts to view Spain as ‘safe’ and Spanish sovereign spreads tighten, then the likelihood of a sovereign restructuring at some stage in Greece actually increases since the authorities would deem it very unlikely that a Greek restructuring would result in a European ‘Lehmans event’.  However, if Spanish sovereign creditworthiness comes under pressure,  then the likelihood of a Greek restructuring taking place would most likely fall, since the risk of contagion from a Greek restructuring to other sovereigns would be seen as too great.

It’s not just the governments that are struggling to reduce leverage.  Households need to reduce debt too, with mortgage debt forming 75% of US household debt, and US household debt is already 91% of US GDP (the UK’s household debt is in fact higher still, at 107% of UK GDP).  More principal writedowns by banks are needed, and the large debt overhang poses further downside risks to housing markets.

Finally, in terms of emerging markets, capital flows have accelerated and this is causing policy dilemmas for a number of emerging market countries.  Some nations (namely China, India and Turkey, but also some countries in Latin America) are experiencing worrying private credit growth rates, and authorities need to allow their currencies to appreciate to prevent overheating and the build-up of financial imbalances.  While emerging markets do not look like they’re about to pop, there are warning signs of bubbles developing.

Last weekend the voters of Iceland said no to honouring claims made against their nation by the British and Dutch governments. These claims originate from the failure of “IceSave” saving accounts. Many depositors in these accounts were based in the UK and Holland. In the wake of the funding crisis the UK and Dutch governments  covered the losses of their respective citizens.

The Icelandics are faced with a dilemma. Do they choose the cheap short-term option of walking away from their debt, or the expensive short-term option of paying up? If they choose the latter, then Iceland will probably garner greater support in terms of future potential borrowing, and a higher possibility of joining the EU club.

It is likely that the next stage of the IceSave process will be in court, and this shows the dilemma of lending to a state as opposed to a corporation. Even if the court rules against Iceland, how will the UK and Dutch governments recover their money? Default risk is lower in sovereign credits than corporates, but recovery is often at the whim of the electorate, and rightly so. Most sovereign states have the benefit of democratic constitutions. When lending to a corporation it is the probability of default and recovery potential that investors have to focus on. When lending to a sovereign it is the willingness and ability of the citizens to repay debt that investors have to focus on.

The claim from the UK and the Dutch is a result of them bowing to their own electorate who had invested with Icelandic institutions, and they were given their money back in full, despite the deposit protection scheme being well publicised. In this case, we have the bizarre situation where a company operating outside its national boundaries has defaulted, the voting members of the sovereign state they operate in get bailed out, and the claim is passed onto another state, whose electorate (not surprisingly) do not wish to pay.

The Icelandic voters have decided they did not want to bail out the UK and Dutch governments, who had bailed out their own voters. Given the structure of the Eurozone banking system, one currency, hugely mobile capital, and a multitude of democracies, Iceland could well be a test case of what happens next (see previous blog on Iceland here). Financial integration without political integration may plain and simply will not work.

A couple of months ago I mentioned the Billion Prices Project – a daily CPI estimator which collects online prices to construct an index which we can compare with the official inflation releases. Sadly there is still no UK measure, but a month after the Japan earthquake and tsunami we can see what appears to be happening there. It looks like there was an intial inflationary shock, but prices have since fallen back again. Another index they produce is the Product Availability index (page down on the previous link); this shows that from a pre-quake base of 100%, only 85% of goods are currently available, reflecting broken supply chains.

Because the BPP looks at online prices only, it is possible that food is under-represented (the methodology detailed on the website is pretty sparse) relative to, say, DVDs and clothing. So the fall back in inflation in recent days might be reflecting discounting as retailers start to suffer. Bond markets however have priced in a significant increase in inflationary expectations. The Japanese inflation linked bond (JGBi) market has stalled in development for some time now – they had always been pretty illiquid, and the longest bond outstanding is now under 8 years to maturity. Perhaps this isn’t surprising in a world where the Nationwide CPI measure has been negative for most of the last 13 years! Looking at breakeven inflation rates as priced by the JGBi market (see below) however, you can see that there has been an upward trend in expected inflation since the depths of the Great Financial Crisis in 2008, and most recently, since the earthquake, the 8 year breakeven rate has increased from minus 0.4% (i.e. deflation on average over the next 8 years) to zero. The Bank of Japan announced a 10 trillion yen increase in quantitative easing following the disaster, and it’s probably this that has lead to higher inflation expectations amongst investors (although the BOJ’s previous attempts at QE had very little impact on inflation or the economy).

Elsewhere on the BPP site you can see that the trend of sharp acceleration of prices in the US relative to the lagged official CPI data continues, and looks consistent with a 3% number, rather than the 2.1% we saw for February. No wonder TIPS are massively outperforming nominal US Treasury bonds. The 5 year US breakeven inflation rate has risen from 0.75% in early 2010 to 2.25% today.

Finally, given the splendid weather in the UK this weekend, please enjoy this spiffing photograph of me out on my velocipede on the Tweed Run through London. Similar photos are likely to also be found soon on the Sartorialist website.

Month: April 2011

Get Bond Vigilantes updates straight to your inbox

Sign up to the BV Mailing List