Tuesday, 29 November 2011

The bond bubble is bursting

Another excellent article from Detlev Schlichter:

“The government can always pay.”

This is a statement that has no basis in fact. Any rational analysis will quickly expose it to be a fallacy. Economic theory, economic history, and plain good old horse sense can demonstrate effortlessly that this statement is an illusion. Yet, it is today a widely held and deeply cherished illusion in the world of finance (and, incidentally, the world of politics). In fact, it has become one of the defining myths of the modern fiat money era. It has for decades provided portfolio managers and bankers with an imaginary refuge from the turbulent world of capitalist “creative destruction”, a ‘safe haven’ where their nerves and capital could rest. The ‘free lunch’ might not have been a feast – only the ‘risk-free rate’ was to be had – but it was better than nothing and anyway a welcome break from capitalism and entrepreneurship. And by the way, if you leverage your government bond portfolio sufficiently with the help of central-bank-provided, zero-cost fiat money, the returns could still be quite handsome.

The fate of myths is that they sooner or later clash with reality. Then they are exposed as myths, which requires a painful giving-up of beloved certainties, a readjustment of paradigms and an abrupt change in behaviour. This is what we have been witnessing in European sovereign bond markets and will soon observe outside Europe as well.
It seems his message is slowly getting through to the mainstream media:

Investors sent Europe’s politicians a painful message last week when Germany had a seriously disappointing government bond auction. It was unable to sell more than a third of the benchmark 10-year bonds it had sought to auction off on Nov. 23, and interest rates on 30-year German debt rose from 2.61 percent to 2.83 percent. The message? Germany is no longer a safe haven.

Since the global financial crisis of 2008, investors have focused on credit risk and rewarded Germany with low interest rates for its perceived frugality. But now markets will focus on currency risk. Inflation will accelerate and the euro may break up in a way that calls into question all euro-denominated obligations. This is the beginning of the end for the euro zone.

Here’s why. Until 2008, investors assumed that all euro- zone sovereign bonds, as well as bank debt, were risk-free and would never default. This made for a wonderfully profitable trade: European banks could buy government debt, finance it at less expensive rates through funding provided by the European Central Bank, and pocket the spread.

The party is almost over. Let's hope the collapse comes quickly, and with minimal collateral damage.

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