The Debt Hangover
Monday, December 14, 2009 at 07:00AM 
If Friday was the day Macro Man had to pay for a wet evening in the company of alcoholic beverages, it was my turn yesterday as I spent the day trying to recover from a night where the amount of alcohol consumed had been beyond excessive. Thus, as I woke up, in agony, some time in the early Sunday afternoon felling like the bloke to the left, I was initially filled with self-pity which gradually gave way to the realization that I had it coming [1].
The idea of hangover as repayment is not, as it turns out, an entirely useless allegory in the context of the themes that dominate the discourse on global markets and the economy moving into 2010.
The Eurozone's Cracking Periphery
Last week we consequently saw the issue of Greek sovereign debt race to the forefront of the agenda with Fitch handing the Greek government an early ill-wanted Christmas present in the form of a downgrade from A- to BBB+ which saw yields rise significantly as well as it brought all kinds of nasty (but important) questions in relation to the Eurosystem/ECB. Firstly, it essentially raised the question of who exactly is going to pay for Greece should push come to shove and secondly; it raised a more technical question of eligible collateral at the ECB and whether the downgrade could, in the event it was followed by the other rating agencies, mean that Greek government bonds would loose their formal standing as eligible collateral at the ECB.
Greek bonds plunged to their lowest in seven months on Dec. 9 and stocks slumped after Fitch Ratings cut Greece one step to BBB+, saying Papandreou’s two-month-old government isn’t doing enough to tame a deficit of 12.7 percent of output, the highest in the European Union. A day earlier, Standard & Poor’s put its A- rating on watch for downgrade.
The yield on Greece’s 2-year bond has surged 127 basis points to 3.15 percent this week, driving it above Turkey’s for the first time.
Edward has already discussed the significance of this Greek tragedy extensively and I really encourage you to carefully read his posts since I can say with the utmost objectivity that they offer the best current round-up of the flurry. Especially, the link between the ECB's decision to withdraw enhanced credit support and the widening spreads in an intra-Eurozone context is absolutely crucial to understand in this case. The following is then a key point;
Well, using ECB facilities made sense for Greek banks for a number of reasons. In the first place, ECB funding is relatively cheaper for Greek banks than for their European peers since the ECB makes no adjustment to the rates charged for the perceived higher risk of the Greek banks. As Goldman Sachs point out a Greek bank operating in Greece pays the same price as a French bank in France, even though the French bank operates in a lower risk environment and should, in theory, be able to finance at lower rates in the market. But this is what enhanced liquidity support is all about, if only those responsible for the financial and economic administration of Greece understood the situation.
Secondly, the current spreads on Greek government bonds (around 200 base points over German 10 year equivalents) offer Greek banks an exceptional arbitrage opportunity, since by taking advantage of the uniform ECB liquidity rate Greek banks can buy higher Greek government bonds with a much higher yield than the government bonds which their French or German counterparts buy. Regardless of the risk implied through by the Greek CDS spread, Greek government bonds carry a zero risk weighting when calculating riskweighted assets for capital purposes. So for Greek banks this arbitrage carries no capital impact whatsoever. That is to say the Greek banks have been doing very nicely indeed out of the Greek sovereign embarassment, thank you very much. Hence it is not difficult to understand the ECB's growing sense of outrage with the situation.(...)
So to be absolutely clear, the Greek banks have been making money from arbitrage on ECB exceptional liquidity funding and in the proces financing the Greek government to carry out spending programmes while at the same time basically hoodwinking the European Commission about what it was they were actually up to. That is to say, the ECB has been effectively paying to lead the EU Commission straight down the garden path.
Needless to say, the ECB is not stupid and even if I, and others, have had hard time showing the direct link between ECB financing and government deficit spending, the situation described above is another matter. Yet, and for all the outrage the ECB and the commission must feel towards Greece (and perhaps Spain and Italy) the obvious problem is naturally what will happen to government yields in the Eurozone once Enhanced Credit Support is wound down.
Comments made last week by ECB Executive Board member Gertrude Tumpel-Gugerell suggest that while the ECB is indeed ready to play hard ball when it comes to normalization, it also looks with worry at the prospects of sharply rising bond yields going into 2010. It would then seem that normalization of monetary policy without a subsequent normalization of fiscal policies that would take the latter on to a more sustainable path entails huge risks for government finances. Moreover, and as Edward has already eloquently detailed, the ECB will not simply sit back and play ball through the continuation of liquidity provisions. And so, we end up with the overall problem with the Eurozone that one set of policy tools for a lot of diverse economies simply do not work and although the ECB may very well "agree", they are not able nor willing to implement special policies for Spain or Greece.
Thus and in my opinion it is, by now, really a question of whether the commission/EU has the needed force and will to force upon Spain and Greece what would effectively be extreme harsh policies in terms of fiscal austerity. Such drastic prospects handed to Spain and Greece by part of their very own brethern could only work if they also came with some form of guarantee from Germany and France that they would help with "help" here being a very clear commitment to . What you need to understand here is then that if the for example Greece and Spain were forced (committed) to move just within the boundaries of the growth and stability pact that stipulates a running fiscal deficit of no more than 3% of GDP, the subsequent deflationary impact would be massive and destructive; and while this may indeed be the inevitable route we much travel here it would be best, I think, realizing that this is exactly the case in a transparent fashion. So far though, both in Spain/Greece and the EU itself the recovery is "on track" and the longer we continue to believe this to be the case the harder it will to reverse. In line with the theme cast above, rising bond yields in 2010 may prove a timely wakeup call.
And in Japan ...
On the back of the BOJ's emergency meeting which effectively re-instigated QE with the promise to provide funding to commercial banks and where the BOJ was also, more or less, arm-wrestled by the MOF into committing to buy additional government debt notes, it seems that the mounting debt is beginning to worry parts of the new government. Consequently, Japanese Finance Minister Hirohisa Fujii was quoted last week of saying that government should "cap" bond sales next year at 44 trillion yen ($495 billion);
(Quote Bloomberg)
Japanese Finance Minister Hirohisa Fujii said the government must cap bond sales at 44 trillion yen ($495 billion) next year, in contrast with Prime Minister Yukio Hatoyama, who indicated he is prepared to abandon the pledge.
“Such a figure doesn’t need to be seen as a big problem for the Cabinet,” Fujii said at a news conference in Tokyo today. “We have to do it,” he said of the bond limit, which was the amount that the previous government budgeted for the current fiscal year ending in March 2010.
Naturally and with some knowledge of the general government debt situation in Japan which will at some point result in a prolonged hangover in the form a debt restructuring, one finds it hard to see this talk of a cap as nothing more but a proverbial drop of water in the ocean. However, it does signify that Mr. Fujii is tuned in to the likelihood that governments will struggle to maintain the fiscal tap open throughout 2010 even if you, in the case of Japan, is likely to be shouldered by a BOJ that stands ready to print the JPYs necessary to soak up large parts of the nominal supply. The point here is simply that Japan won't naturally be immune to a general tendency in which governments will stand to face an increase in their financing costs in 2010.
The 2010 Debt Hangover
Given my emphasis above, it should be no surprise that I agree, at least in part, with Morgan Stanley's Joachim Fels, Manoj Pradhan and Spyros Andreopoulos who recently rolled out the banks' 2010 themes of which the main points are posted over at the GEF. Especially, I like the idea that as exit from monetary QE measures will not be synchronous with the scaling back of fiscal deficit spending, bond yields (especially in key economies) are likely to react as they are no longer supported by the bid from central bank funded liquidity be it from direct or indirect demand. This is interesting since if the former is a prerequisite for the latter we are likely to observe a battle (like the one currently observed in the Eurozone) in which policy makers will be prone to pushing central bankers into supporting deficit spending through outright government bond purchases or other liquidity measures.
Morgan Stanley for their part focuses on the likelihood that QE exit strategies will exactly be halted in their tracks in this context, something which there is ample precedent for in e.g. Japan.
(...) markets are likely to increasingly worry about longer-term fiscal sustainability, and rightly so. Importantly, the issue is not really about potential sovereign defaults in advanced economies. These are extremely unlikely, for a simple reason: most of the government debt outstanding in advanced economies is in domestic currency, and in the (unlikely) case that governments cannot fund debt service payments through new debt issuance, tax increases or asset sales, they can instruct their central bank to print whatever is needed (call it quantitative easing). Thus, in the last analysis, sovereign risk translates into inflation risk rather than outright default risk. We expect markets to increasingly focus on these risks in the year ahead, pushing inflation premia and thus bond yields significantly higher. Put differently, the next crisis is likely to be a crisis of confidence in governments' and central banks' ability to shoulder the rising public sector debt burden without creating inflation.
I agree that this would definitely imply an increase in the focus on government finances and most definitely provide a push to bond yields although I could easily imagine a situation in which bond yields of key economies were to rise regardless of the bid from central banks. Moreover, I have another rather large qualifier here. Consequently, and while I can see this kind of dynamics taking place in the UK, the US and especially in Japan (at least potentially), the Eurozone is an entirely different case. In fact, when MS notes that "they can instruct their central bank to print whatever is needed (call it quantitative easing)", this categorically does not apply to the Eurozone where the ECB has pretty much made it clear that in terms of providing some form of "special" support to some economies this is not going to happen.
So what happens then? Well, we will see won't we. One thing is for sure; just as I spent Sunday regretting decisions the night before, so will some economies likely face equal regrets in 2010.
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[1] - Pictures taken from http://im.rediff.com and http://abhishekkatiyar.files.wordpress.com
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Thanks a lot for your comments.
@Dorothy; I will ship you a mail over Christmas.
@ Micro SD:
Thanks for the info; fascinating if this were indeed true.
@ Evelyn
"Governments have to spend money to prop up the economy and at least this has left the financial system still breathing "
Oh, I agree very much. But the key is that some economies simply don't have the leverage to do it.
Claus
Japan just drafted a record budget:
http://www.reuters.com/article/idUSTRE5BO04M20091225
And, the guys from Zero Hedge are predicting that the US Demand for fixed income needs to increase by 11-fold in 2010:
http://www.zerohedge.com/article/brace-impact-2010-private-demand-us-fixed-income-has-increase-elevenfold-or-else
What I really see are possible countries passing out dead cold in 2010. Instead of a "spend, try to repay, default" course, we're probably going to see a "still pending, things blow-up" scenario.
My question is, in your opinion, which country do you think is least likely to be saved in the case of default? Who will be the Lehman Brothers of sovereign states in 2010 (assuming the predictions of sovereign instability in 2010 and possible defaults do start taking place).
I feel like there are going to be a few "Dubais" where someone steps in to save the day before we start seeing some real action.
And in case you missed, this is a good article at The Big Picture on Sovereign debt:
http://www.ritholtz.com/blog/2009/12/2010-the-year-to-focus-on-sovereign-debt/
Cheers! and great blog!
Thanks a lot for your comment. Obviously, you are right in the main. Most passed budgets for 2010 are thoroughly in red across the developed world.
""still pending, things blow-up" scenario."
Right, I don't disagree entirely here, but I do think that the "market" will begin to focus increasingly on sovereign debt as central banks start removing the support (ex Japan where I expect the BOJ to continue to be buyers of government debt).
"My question is, in your opinion, which country do you think is least likely to be saved in the case of default? Who will be the Lehman Brothers of sovereign states in 2010 (assuming the predictions of sovereign instability in 2010 and possible defaults do start taking place)."
Well, my main list of candidates are in Europe. Latvia and Hungary would be good bets here (if any). It is much more tricky with Spain and Greece since these two have some milage in the short run one would imagine. The key here is whether the IMF needs to be pulled in.
Incidentally, I also made the following point a while ago over at Seeking Alpha about "mandated deleveraging" to support government debt markets.
"I think since government bonds seem to be supported not only from QE but also from "mandated" deleveraging and de-risking of financials' balance sheets. At least, this is the "word on the street" and it will be an important factor. Also regulatory changes may mean that financials need to stoke up on government debt (of which there is plenty) in order to bolster their capital base with "non-risk".
Now, I still among the deflationists so I don't think yields will go up on an overall basis to reflect inflation expectations (or an even stronger expectation of a recovery). However, we may see some quite interesting discrimination between sovereigns and in fact; given the turmoil in Greece, Spain etc the next big jolt to the financial system may exactly be driven by a sharp rise in yields on some of the more risky sovereigns. I mean, a lot of people think that the Bund yield will come down to reflect the ongoing mess in the Eurozone. Fine with me, but what about intra-Eurozone divergence? "
Thanks for the link to BR too.
Claus
Thanks for the response! I got you in my RSS so you'll likely hear more from me.
keep up the good work.