The quest for the safe haven; one haven that’s justified, one that’s certainly not

A lot of the cash that’s been created over the past few years is sloshing around the world trying to find somewhere to hide. There has been a huge bid for anything deemed a safe haven asset, a bid that has been propelled by an imploding Eurozone and US politicians that are seemingly looking to bring its $14 trillion poker game to a spectacular finale by committing collective hara-kiri.

The problem is that if you take the US out of the picture, there aren’t enough non-shaky AAA assets to go around. Germany and France have about $1.7tn of sovereign debt outstanding, although France is probably the next AAA-rated country to find its credit rating under threat. The UK has about $1.2tn of sovereign debt, and gilts have been big beneficiaries recently, but a double dip recession in the UK (which MPC member Martin Weale recently highlighted as a risk) will cause a U-turn on austerity measures which in turn will place the UK’s AAA rating at risk. After the UK, Canada has about $1 trillion of sovereign debt. After that you’re pretty stuck – Australia has about $0.3tn, Sweden has $0.1tn, and there are a few countries with even less debt.

Norway is the safest sovereign in the world if you take the cost of insuring against default from the CDS market, but as you’d expect for the world’s best quality sovereign, Norway has very little sovereign debt. As a result, the demand for Norwegian government bonds has massively outstripped supply, and a large gap has opened up between the yield on Norwegian government bonds and the Norwegian Krone 10 year swap rate. The difference between the cash rate and the swap rate is now at a similar level to that seen in October 2008. We think that the strong bid for government bonds issued by Norway, Sweden and Germany is totally justified though – indeed, we’ve been filling our boots with the stuff over the past few months, and given our well documented ongoing nervousness regarding a number of sovereign states’ creditworthiness, we think that there’s still significant value in the safest AAA markets.

Norwegian government bonds are seeing huge demand

The big safe haven bid has also been hitting some emerging markets, but in contrast to the money flying into Norwegian government bonds, the EM safe haven bid looks plain bonkers.  The chart below shows the recent price action of Brazil’s 30 year US dollar denominated government bond, where spreads over US Treasuries have tightened from 140 basis points at the beginning of June to under 100 basis points now.  Credit ratings don’t count for all that much these days, but if markets think a risk premium of less than 100 basis points is a fair price for a 30 year bond denominated in US dollars that is benchmarked over US Treasuries and is issued by a country that’s rated one notch above junk status then the market’s smoking crack.

Brazil the new safe haven

This isn’t to say that emerging markets as an asset class are poor value. Much of what has driven financial markets over the past 15 years has been a direct consequence of emerging market countries maintaining artificially undervalued exchange rates. The global current account imbalances that have resulted from these policies go a long way to explaining the behaviour of various asset classes over this period. These global imbalances have lessened since 2007, but they still persist. Developed countries need a sharp devaluation versus many of their emerging market counterparts to restore competitiveness, restore economic growth, and ultimately help reduce debt levels. Overheating emerging markets need their currencies to appreciate, and EM currencies should (with a few exceptions) continue to rally versus developed market currencies.

But buying long dated Brazilian US$ denominated bonds is not how to implement this view. We think that the implied default risk from a number of emerging market bonds is far too low – an implied default risk that has been squished by the huge flow of money into EM debt and a relative lack of supply – and we have selectively put on trades across a number of our bond funds that reflect the view that some areas of the hard currency EM debt market are getting dramatically overvalued.

Discuss Article

  1. Klaus Zeltner says:

    Poor you bond managers out there, there is one safe haven: G O L D

    Posted on: 29/07/11 | 11:41 am
  2. Justin Pugsley says:

    I tend to agree with the thrust of this article, the view of emerging markets is far too rose tinted. They may have more growth potential, but they also have a lot of developing to do and what’s to say that won’t go wrong with some of them, and let’s not forget that political risk is often a factor as well.
    They’re also still dependent on the West for much of their exports and investment – the fact that some of them stick so tenaciously to keeping their currencies undervalued is in part testament to that.
    Still I suspect some of these valuations in part reflect the huge liquidity injections by western central banks and the quest for yield – at almost any cost. The latter looks disturbingly familiar, didn’t that get the world into a lot of trouble back in 2008? 

    Posted on: 29/07/11 | 1:30 pm
  3. hutton says:

    what on earth is a safe haven?

    surely, a haven is safe by definition, or maybe there are unsafe havens – please give examples. 

    Posted on: 29/07/11 | 3:27 pm
  4. yellow says:

    what about sub-sovereigns/supra issuers, ie. EIB, KfW or CADES? and what about covered bonds?

    Posted on: 03/08/11 | 4:38 pm
  5. Michael Riddell says:

    Gold – perhaps, although this isn’t the first time there’s been such euphoria about gold.  A bout of severe inflation in the 1970s saw the gold price fly from $100 in mid 1976 to $850 in January 1980, before falling to a low of just above $250 in August 1999.  If you’d bought gold in the late 1970s or early 1980s as an inflation hedge, then you ended up with a pretty horrendous NOMINAL return, let alone inflation adjusted return.  

    Which brings me onto the question of what a safe haven is.  I’d argue that a safe haven is something that’s perceived as being safe at a point in time.  Ex post  you can see that some things that were perceived as being safe havens at the time weren’t actually safe havens at all, and were shown to be very unsafe.  Maybe gold in 1980, or AAA-rated CDOs in 2007.  And yes, if we return to either an inflationary environment or the global economy unexpectedly recovers, then the top rated government bonds will very likely see you nursing losses.  So maybe there aren’t any safe havens at all, although a short dated AAA index linked government bond should protect you against the risk of default and the risk of inflation (although of course not the risk of deflation).  In the blog comment above I was suggesting that investors appeared to have purchased Brazilian government bonds as a safe haven from the threat of a US downgrade, financial crisis or global economic slowdown.  This belief looked highly misplaced, and indeed, as financial markets proceeded to slump in the first two weeks of August, the yield spread on Brazilian government bonds soared to 150 basis points, and is currently just above 130bps.  

    As for the perceived safety of supranationals and covered bonds, this is something that we’ve thought a lot about over the past year too.  It all depends on the strength of the guarantor, or whether there’s a guarantor at all.  KFW is explicitly guaranteed by the German government, although EIB is only implicitly supported by its shareholders, the 27 member states of the European Union. CADES has implicit support from the French government.  As for covered bonds, it depends entirely on the quality of the pool of loans backing the bond, which can vary significantly and of course can vary between countries.

    Posted on: 17/08/11 | 12:17 pm
  6. Michael Downs says:

    Clearly I need to be checking this site more often as I’m the guy that was drinking from the EM debt spigot.
    Fortunately for me, my equities are actually doing worse so it takes my mind of the debt losses.

    Posted on: 22/09/11 | 8:26 pm
  7. The new Big Short – EM debt, not so safe « AFBic says:

    […] that the market was treating EM debt as a safe haven, and the market was therefore smoking crack (see here). The price action in EM hard currency since then suggests that the EM rally was indeed being […]

    Posted on: 29/09/11 | 6:50 pm

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