by Antonio BorrasThere is a well-known Chinese proverb that says "May you live in interesting times" and we certainly are!
From a financial perspective we now face a very interesting yet difficult situation. All major economies (Japan has been doing it for the last 20 years) are currently stimulating their GDP through public initiatives paid with government debt. All of them want a devalued currency to export and be able to reduce stimulus, increase tax revenues and start reducing debt. The problem is that they are all doing it at the same time! As Zerohedge says, "whoever devalues last, loses".
So, if everybody wants a cheap currency, who is left with the strong one? All eyes turn to China but they are reluctant to cede to international pressure and say that currency issues must be kept apart from political discussion. The markets hope that internal inflation and the need to keep credit flowing will force the Chinese government to accept a yuan (or renmibi) appreciation. However, is it possible that all this mess can only be solved thanks to Chinese consumers?
If things work this way, then it is only a question of time that commerce starts to grow globally, unemployment recedes, taxes increase and debt diminishes. But, what if Chinese consumers do not comply with Western desires? We may know what to expect thanks to the Bond Vigilantes.
The Bond Vigilantes
The debt market is far more professional than the stock market (apart from much bigger). It must be understood that it is a market and when there is too much of something, or lack of bidders, prices go down (and when debt prices go down interest rates go up). The bond vigilantes is a term to describe all the fixed income professional investors, much savvier than stock investors, and whose decisions are representative of the confidence in a country or company.
If these professionals start to lose confidence in a country's capacity to pay off its debt, or think that the currency in which this debt is issued is being undermined, they will demand more interest for their investments. This would increase the cost of financing new and old debt (usually refinanced) and put increased pressure on the government budget, forcing them to take specific measures to reduce debt issuance and balance their budget (these measures are typically tax hikes and a reduction of expenditure).
This graph shows that during the last 20 years the 30-year US T-Bonds have been on a secular decline of interest rates. Should the bond vigilantes start to fear the US debt then interest rates would increase and break the blue line on the graph and maybe enter a secular increase. (see graph n#1)
From a financial perspective we now face a very interesting yet difficult situation. All major economies (Japan has been doing it for the last 20 years) are currently stimulating their GDP through public initiatives paid with government debt. All of them want a devalued currency to export and be able to reduce stimulus, increase tax revenues and start reducing debt. The problem is that they are all doing it at the same time! As Zerohedge says, "whoever devalues last, loses".
So, if everybody wants a cheap currency, who is left with the strong one? All eyes turn to China but they are reluctant to cede to international pressure and say that currency issues must be kept apart from political discussion. The markets hope that internal inflation and the need to keep credit flowing will force the Chinese government to accept a yuan (or renmibi) appreciation. However, is it possible that all this mess can only be solved thanks to Chinese consumers?
If things work this way, then it is only a question of time that commerce starts to grow globally, unemployment recedes, taxes increase and debt diminishes. But, what if Chinese consumers do not comply with Western desires? We may know what to expect thanks to the Bond Vigilantes.
The Bond Vigilantes
The debt market is far more professional than the stock market (apart from much bigger). It must be understood that it is a market and when there is too much of something, or lack of bidders, prices go down (and when debt prices go down interest rates go up). The bond vigilantes is a term to describe all the fixed income professional investors, much savvier than stock investors, and whose decisions are representative of the confidence in a country or company.
If these professionals start to lose confidence in a country's capacity to pay off its debt, or think that the currency in which this debt is issued is being undermined, they will demand more interest for their investments. This would increase the cost of financing new and old debt (usually refinanced) and put increased pressure on the government budget, forcing them to take specific measures to reduce debt issuance and balance their budget (these measures are typically tax hikes and a reduction of expenditure).
This graph shows that during the last 20 years the 30-year US T-Bonds have been on a secular decline of interest rates. Should the bond vigilantes start to fear the US debt then interest rates would increase and break the blue line on the graph and maybe enter a secular increase. (see graph n#1)
graph n#1
What to expect from the debt bubble
There is no doubt that we are in a government debt bubble that is trying to offset the implosion of private debt.(see graph #2). Whatever happens in the future government debt must be paid, it cannot grow forever. How is this debt going to be paid?
There is no doubt that we are in a government debt bubble that is trying to offset the implosion of private debt.(see graph #2). Whatever happens in the future government debt must be paid, it cannot grow forever. How is this debt going to be paid?
graph n#2
There are only a few ways to do it:
- Defaulting on the debt: this is a possibility but it would send markets, confidence and the economy to the wall. We all remember the effect of Lehman Brothers’ collapse. I do not rule out that it may happen to a small country in the next few years once economies and markets are stronger, but now everything possible will be done to avoid it. Bond Vigilantes will anticipate this move and liquidity on these bonds would diminish and their prices collapse.
- Paying it: that means that taxes must be increased and expenditure reduced. If emerging economies assume the role of Western consumers then this may be possible, at least to a certain degree, thanks to the restoration of economic activity. However, debt is too big in the US, Japan, UK and certain European countries and it would take a huge amount of political and citizenship will, huge, to assume voluntarily the measures needed to follow this way. Interest rates would hold steady under this situation.
- Inflating the debt: by devaluing the currency in which the debt is issued it is easier to comply with debt repayment. However, the owners of the debt lose money, maybe a lot of money, and these are the Bond Vigilantes.
Personally, I think that the solution would be a combination of paying off and inflating the debt, with a bit more of the latter. The reason is very simple: lack of political will. In any case, be sure that this time there will also be, as in any crisis, a transfer of wealth from those financially illiterate to those financially savvy and solvent.
So, of all the indicators that can be monitored (currencies, stock market, debt, unemployment rates, inflation measures, etc.) I recommend keeping an eye on debt prices to understand what the savvier investors think is coming.
Article Submitted on 29th March, 2010, All Rights Reserved, © SCIBC 2010
| About the Author | |
 |
Antonio graduated as Telecomunications Engineer and joined Everis, an international consulting firm. After several year as manager in the financial services area he decided to follow a different professional career focused on the financial markets, his personal passion. At present he collaborates with BANIF, Group Santander private bank, as wealth manager. |
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