The dearth of safe assets most benefits sovereign issuers… for now
The financial crisis has reduced the ranks of countries with pristine macro fundamentals. Thus, the availability of safe assets has declined precipitously. Investors in a bind where they have funds to invest but a limited number of options, both in terms of yield and in terms of asset quality. The result has been a schizophrenic risk-on risk-off kind of investing environment. I expect this behavior to continue.
This is just an addendum to what I just wrote about Spain’s difficulties. I have been following the debate about the dearth of safe assets and I believe the idea is intriguing and has merit. Two posts I want to highlight here on this are from Matthew Klein at the Economist and Izabella Kaminska at the Financial Times.
The crux here is that as the financial crisis has reduced the ranks of countries with pristine macro fundamentals, the availability of safe assets has declined precipitously. Meanwhile central banks have lowered interest rates to the point where real yields on government bond assets are at historic lows. This puts investors in a bind where they have funds to invest but a limited number of options, both in terms of yield and in terms of asset quality. The result has been a schizophrenic risk-on risk-off kind of investing environment in which periods of increased risk seeking return mentality alternate with periods of panic flows to perceived safe havens. Despite the all clear that policy makers are now giving on this front, I expect this behavior to continue.
In the government bond market, there are two outcomes relevant to the Spain post.
First, countries with sovereign currencies like Australia and Norway, the United States, the United Kingdom and Japan benefit the most from the dearth of safe assets irrespective of their macro and fiscal profiles. This is a consequence of the increasing move to a more unified fiscal-monetary policy framework across a number of different countries. When the central bank and the central government are working hand in glove to support a currency issuers economic goals, default is not an option. And, therefore, all domestic investors can reliably invest in government assets as a safe haven within their currency zone, knowing that no other asset in that currency is safer. This is an important point to make because it is what has sustained Japanese government bonds for twenty years, leading to 30-year JGB nominal rates under 2%.
Second, all sovereign issuers will benefit to some degree, especially with tacit support from the central bank. While the members of the euro zone do not issue debt in their own sovereign currencies, the importance of the decision by the ECB to threaten to use the OMT program cannot be overstated. The ECB has turned what were bonds issued by users of currency into quasi-currency sovereign instruments that approximate the qualities of bonds from actual currency issuers. Investors have piled in again as a result. France, Spain and Italy have benefitted most from this move by the ECB.
Yet, I have my worries here. We remember how the ECB’s first moves to support Italy and Spain in late 2011 collapsed during 2012. They were therefore forced to make their backstops more explicit still via the OMT threat. I do not believe the threat of OMT will be enough to bridge the gap between these quasi-currency sovereign government bonds and the real ones. I believe we will see another spate of risk-off behavior that causes yields in Spain and Italy to rise, triggering actual OMT implementation. And I believe this will occur in 2013.
But be under no mistake here about the power of bond market vigilantes. Their power is only relevant to bond issuers that borrow in a currency whose creator refuses to backstop them. The vigilantes are powerless against issuers that can create money. In a world in which safe assets are in short supply and that is beset by economic crisis, this dichotomy between currency issuers and currency users matters. During the coming risk-off periods, this favours currency issuers over currency users until the central bank put kicks in and quasi-issuer paper rallies on the back of central bank backstops.