Running through Italian default scenarios

The most important debate of our lifetimes is now ongoing. For many, the answer will be existential. First, the question: Should the ECB “write the check’ for the euro area national governments? In thinking about the answer to this all-important question, I prefer to shift the focus by changing the verb “should” to “will”.

Answering this slightly different question is much more important than answering the first question for you as an investor, a business person and as a worker. If the ECB writes the check, the economic and market outcomes are vastly different than if they do not. Your personal outlook as an investor, business person or worker will change dramatically for decades to come based upon this one policy choice and how well-prepared for it you are. The right question to ask then is: Will the ECB “write the check’ for the euro area national governments?

To date, my answer to this question has been yes. See, for example, my thoughts on why questioning Italy’s solvency leads inevitably to monetisation and why Investors will buy Italian bonds after ECB monetisation. But what if the ECB doesn’t write the check? What if the ECB let’s Italy default, what then?

Here’s my thinking on that score.

Italian death spiral

Let me start off with what I have previously written from two posts from November 7th.

The euro zone periphery was a sideshow. This stuff with Italy is the real deal. With yields at 6.7% and rising, it’s game over for the euro zone. The extend and pretend stuff ain’t gonna work.

And if you are an investor, this is the moment of truth. Everything – every asset class – depends on how the euro zone performs in the Italian Job. There are only two outcomes, here. If Italy blows up, a Depression is upon us; banks would be insolvent, CDS triggers would implode the system, bank runs would begin, stock markets would crash, and you will would see sovereign debt yields go to unbelievable lows for nations with a lender of last resort. If Italy survives, I would expect a monster rally in periphery debt, stock markets, and bank shares and a selloff in CDS at the minimum. However, the euro zone is already in recession so that rally will not be sustained.

Forget about Berlusconi and austerity in Italy. That’s a sideshow too. Austerity is not going to bring Italian yields back down. These days are over, folks.

Here’s the real problem: Italy needs to run a primary budget surplus (excluding interest payments) of about 5 percent of GDP, merely to keep its debt ratio constant at present yields. That’s never going to happen. So the yields for Italian bonds must come down or Italy is insolvent. More than that, a stressed Italy means a stressed euro zone and a deepening recession with all of the attendant ills that means: Ireland would suddenly start missing deficit targets for example. Bank shares would be under stress, triggering more Dexia’s. So even if Italy limps along at 7 percent yields, we will see a nasty double dip recession and bank failures. And we know that yields will rise. Last November, we were discussing Ireland in the same way with its yields at these levels. Soon, the yield went to 9% and Ireland was forced into a bailout – one that Italy is to big to give.

So we are definitely facing a real financial Armageddon scenario here.

Italy! Italy! Italy!

Here’s what I am saying.

  1. Italy needs to run a primary budget surplus (excluding interest payments) of about 5 percent of GDP, merely to keep its debt ratio constant at present yields. It won’t ever be able to do so.
  2. Therefore, yields for Italian bonds must come down or Italy is insolvent as it must roll over 300 billion euros of debt in the next year alone.
  3. Austerity is not going to bring Italian yields back down. First, Italian solvency is now in question and weak hands will sell. Moreover, investors in all sovereign debt now fear that they are unhedged due to the Greek non-default plan worked out in Brussels last month. As Marshall Auerback told me, any money manager with fiduciary responsibility cannot buy Italian debt or any other euro member sovereign debt after this plan.

Conclusion: Italy will face a liquidity-induced insolvency without central bank intervention. Investors will sell Italian bonds and yields will rise as the liquidity crisis becomes a self-fulfilling spiral: higher yields begetting worsening macro fundamentals leading to higher default risk and therefore even higher yields.

Soft depression

I believe the global economy is in a cyclical upturn within a larger depression. Two years ago, I wrote:

… all countries which issue the vast majority of debt in their own currency (U.S, Eurozone, U.K., Switzerland, Japan) will inflate. They will print as much money as they can reasonably get away with. While the economy is in an upswing, this will create a false boom, predicated on asset price increases. This will be a huge bonus for hard assets like gold, platinum or silver. However, when the prop of government spending is taken away, the global economy will relapse into recession.

Credit Writedowns, Oct 2009

Last week I wrote that this is “a soft depression scenario where the countries with a true lender of last resort can backstop without problems.” The problem, however is that the ECB is not a true lender of last resort as we are now seeing.

Should the ECB go all-in or not? There aren’t a lot of options. No one is going to buy Italian bonds at a low yield without a backstop, irrespective of austerity now that the insolvency genie is out of the bottle. With a backstop, some people will. An Italian default equals the insolvency of the Italian banking system. An Italian default means massive losses for German and Dutch banks and beyond. Any scenario in which there is an Italian default leads to a Depression with a capital ‘D’. The question is a political one and, hence, unpredictable. The Germans (and Dutch) either allow the backstop or face Depression. It’s as simple as that.

Italy’s debt woes and Germany’s intransigence lead to Depression

Outlining the Armageddon scenario

This is the crucial piece in understanding how to protect yourself in the event the ECB decides to not act as a lender of last resort for the euro area national governments. This is a true Armageddon and Depression scenario.

The reason no real alternative to the ECB’s acting as a lender of last resort is offered by hawkish types is because the alternative is economic collapse – and recognising this is not politically palatable. We know that Italy will default without the central bank based on the analysis above. Italy’s default would trigger a cascade of interconnected bank runs default and Depression as did the insolvency of Creditanstalt in 1931. Could Italy unilaterally exit the euro zone and redominate euro debts at par into a new Lira currency to forestall the default? Perhaps. That is something to consider at a later date. For now, here’s what will happen if Italy defaults.

  1. Credit event: An Italian default would be a credit event, meaning it could not occur under the voluntary arrangement which the EU is trying to force through for Greece because Italy is simply too large for banks to willingly take the writedowns needed to deal with its insolvency. Doing so would render many financial institutions insolvent. Even in the Greek case, I doubt whether they will get enough participation from the private sector to meaningfully reduce the Greek sovereign debt load. So, an Italian default would be uncontrolled and immediately crystallise losses that must run through the balance sheets of everyone holding their bonds.
  2. Italian bank run: Once Italy defaults, Italian banks would be insolvent as a result of these losses since they are the largest holders of Italian sovereign debt. Given the 10 billion euro writedown at Unicredit just yesterday, we can see these banks are already weak. Therefore, we should anticipate wholesale bank runs in Italy beyond just the weakest banks.
  3. Spain and Slovenia insolvency: Other weaker sovereign creditors within the euro area without IMF funds would come under heavy selling pressure. This includes Spain and Slovenia first but would also include Belgium later and perhaps Austria due to its bank exposure to Eastern Europe. Spain’s yields have already crossed 6% and Slovenia’s have already crossed 7%. These governments would default as well then, cascading the losses onto their banking systems. Defaults here would lead to domestic bank insolvency and bank runs as in Italy. Countries like Ireland, Portugal and Greece would want to default in order to escape the suffocating strictures of austerity given the now untenable solvency path that a deep Depression would cause. Likely, these countries would default as well. Analysts like Sean Egan estimate eventual losses in Greece will be 90%. In the Italian default scenario, these losses would crystallise overnight.
  4. Contagion into Eastern Europe: Unicredit’s losses included significant writedowns in Eastern Europe and Central Asia (Ukraine and Kazakhstan). One area of contagion could be to other banks with exposure to weak economies elsewhere in Eastern Europe like Hungary and Slovenia. Greek, German and Austrian banks would be most vulnerable because of exposure to central Europe and the Balkans. Hungary, already under threat of a sovereign downgrade to junk, amidst a record decrease in the Forint/Euro exchange rate, would suffer contagion. the currency would come under heavy selling pressure. Other weaker sovereign debtors would be affected as well.
  5. Euro bank insolvency: Other debtors with significant exposure to Italy would suffer huge writedowns. Core bank exposure to Italian debt an order of magnitude larger than periphery combined. Financial institutions with exposure could be recapitalised by the state, however. The questions here for the likes of Germany, France and the Netherlands are a) how explicit a backstop will these banks get? would bond holders take losses; b) how would this affect the sovereign debt level and credit rating? c) how would this lack of capital affect credit availability and economic growth?
  6. Credit default swaps: As an Italian default would be a credit event, it would trigger credit default swaps, many of which were sold by American financial institutions. Would these institutions pay out? Could they? How would Italian losses affect their capital base? The same questions for euro countries become applicable here as well as American banks could be recapitalised by the state. (Will Americans allow another bailout?): a) how explicit a backstop will these banks get? would bond holders take losses; b) how would this affect American sovereign debt level and credit rating? c) how would this lack of capital affect credit availability and economic growth in the US?

There are a lot of other potential areas where this could go like capital controls, civil unrest, eurozone breakup, government coups, etc, etc. All of that is speculation. But above are the six parts I see as a sure thing: credit event, Italian bank run, Spain and Slovenia insolvency, contagion into Eastern Europe, some euro bank insolvencies and credit default swap triggers. Clearly, this would mean an economic downturn of at least the magnitude of the Great Depression.

I also tend to think contagion will spread throughout the eurozone until it breaks apart – and we do see yields rising right across the euro zone, today in France, Austria and even the Netherlands:

This is a rolling crisis wave through the eurozone infecting more countries, closer and closer to the core. As Marshall wrote recently, this is a structural problem. All of the euro zone countries face liquidity constraints and all of them will eventually succumb to the rolling wave of yield spikes one by one until we get a systemic solution: full monetisation and union or break up.

Felix Zulauf on the inevitability of further crisis in Europe, July 2011

Protecting your wealth

Hedging against this outcome means preparing for black swan scenarios in stocks, government bonds, currencies, commodities and precious metals. This is a world of unpredictable policy paths that will certainly involve civil unrest, government repression and economic nationalism, but may also involve competitive currency devaluations, currency controls, and trade wars.

My view is that such a scenario will mean significant dead weight economic loss due to debt deflation dynamics. Economic output would decline significantly, as would stocks and high-yield debt. Commodity prices would also decline. But depending on the policy response of governments, bonds and precious metals are wildcards.

Governments like Norway’s are protected because of low debt and rich natural resources. On the other hand, governments like Australia’s and Canada’s are exposed because of significant household sector indebtedness and high property valuation. In essence, there is nowhere to hide in the sovereign bond area. As a foreign investor in sovereign debt, you want to know where the currency and the interest rate are going and neither is foreseeable in this train of events.

If governments try to inflate their way out, precious metals might be a good safe haven, although paper gold presents a problem of reliability and physical gold is subject to confiscation. On the farmland front, as Jim Grant testifies, yields are already very low, so you have to wonder how much upside there is to that trade. Obviously, in a world of financial repression and competitive currency depreciation, those investments won’t necessarily lose value.

Highly rated corporate bonds and high quality dividend paying stocks may well be the best safe havens.

Those are my thoughts on what an Italian default would mean. The overall thrust of the arguments here is that a default would be economically catastrophic and put into play a lot of outlier scenarios. The potential for large losses would be significant, and, therefore it pays to think about how to protect your wealth in such an environment, given that serious policy makers believe letting Italy default is a justifiable policy choice.

25 Comments
  1. Gordon Nash says

    The ramifications of this unwinding are breathtaking. Thank you for your succinct analysis.

  2. Gordon Nash says

    The ramifications of this unwinding are breathtaking. Thank you for your succinct analysis.

  3. Troyounce says

    So that’s the good news. Now the bad news.

  4. Anonymous says

    So that’s the good news. Now the bad news.

  5. John Haskell says

    1. It’s interesting to note that Slovakia (debt/GDP 35%) just blew up a bond auction… this should offer some insights into how much austerity would still not be enough to “restore confidence.”

    2. It’s entirely possible that the ECB could somehow make up its mind to “write the check,” but show up late.  Or a new Italian government would just throw in the towel on the perpetual austerity that the ECB would demand.

    3. How does France not have a massive bank run the day after an Italian default?
    4. Hey guys, I had ten billion euros and now I can’t find it!  When I last saw it, it was somewhere in Kazakhstan….

    1. Edward Harrison says

      Good points. Slovenia is another one to think about this way too. Their debt to GDP is low, 50%. Yet their yields are now 7%. In Argentina, the same was also true when they defaulted a decade ago. The debt to GDP levels were MUCH lower than they are in the eurozone. I think this points to liquidity crises and foreign currency obligations as a death sentence.

      I think the ECB will almost certainly not ‘write the check’ until the eurozone is on death’s door and we’ll just have to see what happens then. That’s what I said here:

      https://pro.creditwritedowns.com/2011/11/italy-italy-italy.html

  6. Anonymous says

    1. It’s interesting to note that Slovakia (debt/GDP 35%) just blew up a bond auction… this should offer some insights into how much austerity would still not be enough to “restore confidence.”

    2. It’s entirely possible that the ECB could somehow make up its mind to “write the check,” but show up late.  Or a new Italian government would just throw in the towel on the perpetual austerity that the ECB would demand.

    3. How does France not have a massive bank run the day after an Italian default?
    4. Hey guys, I had ten billion euros and now I can’t find it!  When I last saw it, it was somewhere in Kazakhstan….

    1. Edward Harrison says

      Good points. Slovenia is another one to think about this way too. Their debt to GDP is low, 50%. Yet their yields are now 7%. In Argentina, the same was also true when they defaulted a decade ago. The debt to GDP levels were MUCH lower than they are in the eurozone. I think this points to liquidity crises and foreign currency obligations as a death sentence.

      I think the ECB will almost certainly not ‘write the check’ until the eurozone is on death’s door and we’ll just have to see what happens then. That’s what I said here:

      https://pro.creditwritedowns.com/2011/11/italy-italy-italy.html

  7. Edp says

    Great post! We really are in Russian roulette world of investing. In that “game” the odds of one “winning” are 5 to 1 but no one plays, as the consequences of being wrong are terminal. I think the scenarios you present in equity market responses are accurate but how does one play it if positioned and wrong. How does one employ any kind of “risk” management to limit losses if the market gaps huge against you on headline news? Yet the temptation to do “something” in the markets is huge based on a lack of alternatives. It is incredible to me that the total earnings you would make from buying a 5-year US Treasury note (1825 days) at 1.00% on a buy and hold would equal the one-day profit or loss movement (5.00%) of some US equities. I will preserve cash and see how it all sorts out.

  8. Edp says

    Great post! We really are in Russian roulette world of investing. In that “game” the odds of one “winning” are 5 to 1 but no one plays, as the consequences of being wrong are terminal. I think the scenarios you present in equity market responses are accurate but how does one play it if positioned and wrong. How does one employ any kind of “risk” management to limit losses if the market gaps huge against you on headline news? Yet the temptation to do “something” in the markets is huge based on a lack of alternatives. It is incredible to me that the total earnings you would make from buying a 5-year US Treasury note (1825 days) at 1.00% on a buy and hold would equal the one-day profit or loss movement (5.00%) of some US equities. I will preserve cash and see how it all sorts out.

  9. fresno dan says

    There’s a Dutch movie about the Holocaust called “Black Book” apparently based on a true story.
    There is a scene at the beginning where a number of Jews have bribed the Nazis to let them escape and what wealth they have left is in the form of gold and jewerly.  The Nazis put them on a boat to “escape” but actually rob and kill them. 

    In an insane world, there is no safe haven…

  10. fresno dan says

    There’s a Dutch movie about the Holocaust called “Black Book” apparently based on a true story.
    There is a scene at the beginning where a number of Jews have bribed the Nazis to let them escape and what wealth they have left is in the form of gold and jewerly.  The Nazis put them on a boat to “escape” but actually rob and kill them. 

    In an insane world, there is no safe haven…

  11. William Roth says

    Ed-
    Thanks for your excellent analysis. Could you please clarify a couple of things for me. How much more can the ECB do buying bonds in a sterilized manner-what is the size of their balance sheet and how much is left that is not PIIGS bonds? Also when they sterilize, what have  they been exchanging for the Italian bonds they buy?

    1. Edward Harrison says

      William, here is a link to the euro area aggregated balance sheet:
      http://www.ecb.int/stats/money/aggregates/bsheets/html/outstanding_amounts_index.en.html

      I don’t believe the ECB releases its balance sheet publicly however. I could be wrong but i haven’t seen it.

  12. William Roth says

    Ed-
    Thanks for your excellent analysis. Could you please clarify a couple of things for me. How much more can the ECB do buying bonds in a sterilized manner-what is the size of their balance sheet and how much is left that is not PIIGS bonds? Also when they sterilize, what have  they been exchanging for the Italian bonds they buy?

    1. Edward Harrison says

      William, here is a link to the euro area aggregated balance sheet:
      http://www.ecb.int/stats/money/aggregates/bsheets/html/outstanding_amounts_index.en.html

      I don’t believe the ECB releases its balance sheet publicly however. I could be wrong but i haven’t seen it.

  13. ChrisBern says

    1) Haven’t seen much talk about Italian/Spanish corporations/banks dealing with these higher interest rates…most economists are only focusing on government borrowing costs not corporate borrowing costs.

    2) If ECB does completely backstop everyone, I wonder if that will ultimately lead to country downgrades anyway due to the ECB needing higher capital from those same countries?  Sovereign downgrades could potentially lead to the same type of debt revulsion as this liquidity crisis has, though on a smaller scale I would think.

    3) After reading “FT interview transcript: Jens Weidmann” on ft.com from Nov 13th, I’m not as sure as I once was that the ECB will definitely backstop these countries–at least not until we’re standing at the ledge.  I realize the Bundesbank president does not have direct control over ECB decisions…nonetheless there is tremendous influence there.

    1. Edward Harrison says

      Hi Chris, good points. Two thoughts.

      1. International Spanish and Italian corporations have large asset and revenue bases outside of Spain and Italy. That means they are hedged. Repsol is really an international play and we should expect it’s yields to diverge from the sovereign. Increasingly this will be the case for corporates. That’s why I see high grade corporate bonds as a safe haven. but even domestically, a corporate within a currency user area can actually have lower yields than the sovereign because the sovereign is no longer the risk free rate benchmark. I think the biggest problem in Spain/Italy corporate lending is for banks because there the contagion is large.

      2. Yes, Weidmann is pushing a very hard line. It pays to believe him and hedge for the eventuality that the ECB pushes it too far and the global economy relapses down in a very nasty way.

      1. Anonymous says

        But Santander is very heavily invested in the UK, and UK real estate. It has even more potential property losses in the UK to deal with so I would think caution should be key here. 

        Somehow I anticipate things going awry and am stocking up on the canned goods in preparation.

  14. Edward Harrison says

    Hi Chris, good points. Two thoughts.

    1. International Spanish and Italian corporations have large asset and revenue bases outside of Spain and Italy. That means they are hedged. Repsol is really an international play and we should expect it’s yields to diverge from the sovereign. Increasingly this will be the case for corporates. That’s why I see high grade corporate bonds as a safe haven. but even domestically, a corporate within a currency user area can actually have lower yields than the sovereign because the sovereign is no longer the risk free rate benchmark. I think the biggest problem in Spain/Italy corporate lending is for banks because there the contagion is large.

    2. Yes, Weidmann is pushing a very hard line. It pays to believe him and hedge for the eventuality that the ECB pushes it too far and the global economy relapses down in a very nasty way.

    1. David Lazarus says

      But Santander is very heavily invested in the UK, and UK real estate. It has even more potential property losses in the UK to deal with so I would think caution should be key here. 

      Somehow I anticipate things going awry and am stocking up on the canned goods in preparation.

  15. Geoff says

    Congrats for the Krugman plug.  Too bad he didn’t link directly to your site.

    1. Edward Harrison says

      Thanks, Geoff. I do like the traffic but he reads Naked capitalism and I suspect he doesn’t read Credit Writedowns.

  16. Geoff says

    Congrats for the Krugman plug.  Too bad he didn’t link directly to your site.

    1. Edward Harrison says

      Thanks, Geoff. I do like the traffic but he reads Naked capitalism and I suspect he doesn’t read Credit Writedowns.

  17. David Lazarus says

    I agree with you that without ECB support and low interest rates then Italy is in a death debt spiral. The only problem is will it be an orderly default? Should Greece implode next month when it is unable to pay off its next tranche it will be disorderly. The credit markets might freeze up again because the question will be who holds the toxic debts or potential liability for CDS? The problem is that there are now more and more balls there for the ECB to juggle. WIth the supposedly safe northern countries now being targeted then it might get to the point where they drop one ball and it panics the juggler. The era of extend and pretend is now over but can they push the problem out a few more quarters?

  18. Anonymous says

    I agree with you that without ECB support and low interest rates then Italy is in a death debt spiral. The only problem is will it be an orderly default? Should Greece implode next month when it is unable to pay off its next tranche it will be disorderly. The credit markets might freeze up again because the question will be who holds the toxic debts or potential liability for CDS? The problem is that there are now more and more balls there for the ECB to juggle. WIth the supposedly safe northern countries now being targeted then it might get to the point where they drop one ball and it panics the juggler. The era of extend and pretend is now over but can they push the problem out a few more quarters?

  19. AntiMooosse says

    What about actions by the IMF?  It appears to me that Merkel is playing a game of high stakes chicken with the US, as she tries to force the US through the IMF to bailout the EZ periphery.  Merkel probably believes the US is the cause of the EZ’s problems due to the criminally fraudulent misrepresentation of CDOs and MBSs by US banks, while the US (Geithner/Obama) believe that Germany is the source of the EZ problems due to its export dependent economy and past German friendly ECB policies causing EZ financial imbalances.  Everyone knows that in a game of chicken neither side blinks until they’re right at the edge of the abyss,and sometimes not even then.

  20. AntiMooosse says

    What about actions by the IMF?  It appears to me that Merkel is playing a game of high stakes chicken with the US, as she tries to force the US through the IMF to bailout the EZ periphery.  Merkel probably believes the US is the cause of the EZ’s problems due to the criminally fraudulent misrepresentation of CDOs and MBSs by US banks, while the US (Geithner/Obama) believe that Germany is the source of the EZ problems due to its export dependent economy and past German friendly ECB policies causing EZ financial imbalances.  Everyone knows that in a game of chicken neither side blinks until they’re right at the edge of the abyss,and sometimes not even then.

  21. gg555 gg555 says

    Thanks for the explanation and analysis. One question: When you say, “there is nowhere to hide in the sovereign bond area,” and “highly rated corporate bonds and high quality dividend paying stocks may well be the best safe havens,” are you referring even to the U.S.? In the default scenario you outline do you see even U.S. Treasuries as not a safe haven? Does that mean you think in this scenario it’s more likely that the U.S. government would default than corporations with highly rated bonds?

    1. David Lazarus says

      It should depend on your location. Trade offshore and you add currency risk to the equation. The safest currencies are ones that are backed by a lender of last resort i.e. not the Euro. Dividend paying stocks from businesses with strong balance sheets are probably the safest bets. Sovereigns will be questionable until the banks have been re-capitalised and mark to market restored. For the next decade playing safe and wealth retention should be first priority. 

      1. gg555 gg555 says

        Thanks for the response. My understanding is that U.S. Treasuries are understood by many to be the safest most liquid investments in the world. So when you say “sovereigns will be questionable,” I still would like to know if you’re including U.S. Treasuries in this. From my perspective, to a certain extent, there’s everyone else and then there’s U.S. Treasuries, so “sovereigns” elides this distinction. Are you really suggesting that if Italy defaults and we get the scenario Harrison outlines in his article above, that this could lead to the U.S. government defaulting on its debt? (I’m bracketing the question of currency risk on U.S. treasuries, since I understand that this would vary depending on whether you’re in the U.S. or elsewhere.) And is this really what Harrison thinks, when he says, “there is nowhere to hide in the sovereign bond area”? That the U.S. could default on its debt?

        1. David Lazarus says

          US Treasuries are probably the safest of all bonds depending on the competence of Congress. If they trigger a default then all bets are off. As for sovereigns it depends on the level of debts that have and any deficits. If those are manageable then it really should not be a problem, though you should factor in any nasties like a recession. The only way the US could be at risk is if they back stop the banks again this time for credit default swaps. The banks could have tens of trillions of liability that would be impossible for anyone to cover. If they are suckered into another guarantee then the US would be in serious trouble. At that point the politicians will have a choice save the banks or the state? Even the UK is a risk, which while protected by a sovereign currency and lender of last resort. It’s banks are also better capitalised than many others but some have large exposure to CDS and other derivatives which could be fatal, add in a european bank collapse which will significantly impact the UK banks, and the UK will have even more problems. An Irish default will cost the UK €46 billion just for RBS bank. So while the UK should be a safe haven, there could be downsides, that is why there will be nowhere to hide in the sovereign bond area. The US will not default unless its politicians mess up. That could be not agreeing a new debt limit or bailing out the banks again. Either could happen. 

          1. gg555 gg555 says

            Thanks for the further explanation. I wonder if I’m misunderstanding the used of the term “sovereign.” Does the statement “sovereign bond area” include the US? It seems like in your explanation above when you say “sovereigns” your perhaps not talking about the US. I assumed sovereign bond just meant any bond issued by a sovereign government.

            I’m just looking online as some definitions. It looks like “sovereigns” means bonds issued by a goverment in a currency other than their own. So would this not include any bonds issued by a government in their own currency? Thanks for any further clarification.

    2. Edward Harrison says

      Sorry for the delayed response. When I wrote the part about sovereign debt I was thinking about global asset allocation. A lot of people are going to want to escape low bond yields and stock market volatility at home by diversifying into other asset classes or by shifting funds abroad. In the US, Treasuries have already seen the lion’s share of their appreciation. Upside is very limited. Downside is not.

      Investing abroad then leaves one open to currency risk and I think currency risk is going to be a major factor in the political economy of a post-Euro sovereign default world. Any debt deflationary trends will almost certainly be met in some major economies with a reflationary bias that has a currency effect.

      I think high quality corporate bonds are a good way to get yield pickup for little risk over Treasuries in a world in which Treasury upside is limited.

      1. gg555 gg555 says

        Thanks for the reponse.

        I see, so when you wrote, “there is nowhere to hide in the sovereign bond area,” and “highly rated corporate bonds and high quality dividend paying stocks may well be the best safe havens,” you were not speculating that an Italian default scenario might lead to the U.S. defaulting on its debt. You were just viewing high grade corporates as somewhere one could go for more yield and potential appreciation, with little extra credit risk over treasuries? (Given that the yield on U.S. treasuries is already very low and they’ve already appreciated a lot in value.)

        1. Edward Harrison says

          That’s right. The days of viewing the sovereign credit in any currency space as the risk free rate for bonds are over. High quality corporates are likely to hold their value as much or more than their respective government bonds. This is true more in the euro zone than in the US. But it is also true in the US.

          Unless one wants exposure to price appreciation from future deflation and invests in longer-duration paper, treasuries are not a good place to be at these levels.

  22. gg555 gg555 says

    Thanks for the explanation and analysis. One question: When you say, “there is nowhere to hide in the sovereign bond area,” and “highly rated corporate bonds and high quality dividend paying stocks may well be the best safe havens,” are you referring even to the U.S.? In the default scenario you outline do you see even U.S. Treasuries as not a safe haven? Does that mean you think in this scenario it’s more likely that the U.S. government would default than corporations with highly rated bonds?

    1. Anonymous says

      It should depend on your location. Trade offshore and you add currency risk to the equation. The safest currencies are ones that are backed by a lender of last resort i.e. not the Euro. Dividend paying stocks from businesses with strong balance sheets are probably the safest bets. Sovereigns will be questionable until the banks have been re-capitalised and mark to market restored. For the next decade playing safe and wealth retention should be first priority. 

      1. gg555 gg555 says

        Thanks for the response. My understanding is that U.S. Treasuries are understood by many to be the safest most liquid investments in the world. So when you say “sovereigns will be questionable,” I still would like to know if you’re including U.S. Treasuries in this. From my perspective, to a certain extent, there’s everyone else and then there’s U.S. Treasuries, so “sovereigns” elides this distinction. Are you really suggesting that if Italy defaults and we get the scenario Harrison outlines in his article above, that this could lead to the U.S. government defaulting on its debt? (I’m bracketing the question of currency risk on U.S. treasuries, since I understand that this would vary depending on whether you’re in the U.S. or elsewhere.) And is this really what Harrison thinks, when he says, “there is nowhere to hide in the sovereign bond area”? That the U.S. could default on its debt?

        1. Anonymous says

          US Treasuries are probably the safest of all bonds depending on the competence of Congress. If they trigger a default then all bets are off. As for sovereigns it depends on the level of debts that have and any deficits. If those are manageable then it really should not be a problem, though you should factor in any nasties like a recession. The only way the US could be at risk is if they back stop the banks again this time for credit default swaps. The banks could have tens of trillions of liability that would be impossible for anyone to cover. If they are suckered into another guarantee then the US would be in serious trouble. At that point the politicians will have a choice save the banks or the state? Even the UK is a risk, which while protected by a sovereign currency and lender of last resort. It’s banks are also better capitalised than many others but some have large exposure to CDS and other derivatives which could be fatal, add in a european bank collapse which will significantly impact the UK banks, and the UK will have even more problems. An Irish default will cost the UK €46 billion just for RBS bank. So while the UK should be a safe haven, there could be downsides, that is why there will be nowhere to hide in the sovereign bond area. The US will not default unless its politicians mess up. That could be not agreeing a new debt limit or bailing out the banks again. Either could happen. 

          1. gg555 gg555 says

            Thanks for the further explanation. I wonder if I’m misunderstanding the use of the term “sovereign.” Does the statement “sovereign bond area” include the US? It seems like in your explanation above when you say “sovereigns” your perhaps not talking about the US. I assumed sovereign bond just meant any bond issued by a sovereign government.

            I’m just looking online as some definitions. It looks like “sovereigns” means bonds issued by a goverment in a currency other than their own. So would this not include any bonds issued by a government in their own currency? Thanks for any further clarification.

    2. Edward Harrison says

      Sorry for the delayed response. When I wrote the part about sovereign debt I was thinking about global asset allocation. A lot of people are going to want to escape low bond yields and stock market volatility at home by diversifying into other asset classes or by shifting funds abroad. In the US, Treasuries have already seen the lion’s share of their appreciation. Upside is very limited. Downside is not.

      Investing abroad then leaves one open to currency risk and I think currency risk is going to be a major factor in the political economy of a post-Euro sovereign default world. Any debt deflationary trends will almost certainly be met in some major economies with a reflationary bias that has a currency effect.

      I think high quality corporate bonds are a good way to get yield pickup for little risk over Treasuries in a world in which Treasury upside is limited.

      1. gg555 gg555 says

        Thanks for the reponse.

        I see, so when you wrote, “there is nowhere to hide in the sovereign bond area,” and “highly rated corporate bonds and high quality dividend paying stocks may well be the best safe havens,” you were not speculating that an Italian default scenario might lead to the U.S. defaulting on its debt. You were just viewing high grade corporates as somewhere one could go for more yield and potential appreciation, with little extra credit risk over treasuries? (Given that the yield on U.S. treasuries is already very low and they’ve already appreciated a lot in value.)

        1. Edward Harrison says

          That’s right. The days of viewing the sovereign credit in any currency space as the risk free rate for bonds are over. High quality corporates are likely to hold their value as much or more than their respective government bonds. This is true more in the euro zone than in the US. But it is also true in the US.

          Unless one wants exposure to price appreciation from future deflation and invests in longer-duration paper, treasuries are not a good place to be at these levels.

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