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Trading Lessons

No Bond Market Vigilantes Or Vultures Need Apply

Interest-Rates / International Bond Market Sep 11, 2013 - 07:32 AM GMT

By: Raul_I_Meijer

Interest-Rates

With media and technology becoming faster and more pervasive at a rapid clip, it shouldn't perhaps be a big surprise to see the ease with which war-mongering news flashes come to dominate the story of the day. But maybe this should be received with an increasing dose of skepticism, maybe we should today, even more than before, try to figure out who benefits from one story dominating all major headlines, as if all other things going on are only of secondary importance, especially since new technologies allow those headlines to become so much more pervasive, coming in at an ever faster rhythm, that they are today's true bombardments.


Watch what they do, not what they say, remember? Really, the US and France are going to bomb Russia's only Middle East foothold? What are the odds? How does that fit in with relations in today's political power field? There was a similar popular tale a few years back of Israel - alone or with US support - preparing to bomb Iran's nuclear facilities and risking the closure of the Strait of Hormuz. Where's that story now? It fizzled out into oblivion. It's understandable that we are all very wary of warfare, but we shouldn't forget that such levels of wariness can be easily (ab)used to play with our minds, and to focus our attention away from other events.

One such event, which we should shift more of our attention to, is currently happening in sovereign bond markets. There are some curious recent developments that warrant scrutiny. And questions.

One aspect we need to know more about is the one Nicole talked about last week in Promises, Promises ... Detroit, Pensions, Bondholders And Super-Priority Derivatives: super-priority, through which in effect the financial industry has fabricated a way to - almost - always get first dibs at whatever assets are left in case of a default.

In essence, whether we're talking defaults of companies, cities, states or even countries, counterparties of derivatives will have preference over everyone else when bankruptcy looms. In many cases, it's even debatable whether they have to wait for an actual default to start hauling out the kitchen sink. And I know that this is a highly simplified representation of facts, that there are all sorts of questions and issues, and moreover they differ from case to case and from contract to contract, but that doesn't take away from the overall picture: super-priority at the very least creates an highly uneven playing field, in which many parties will find that when they want to get what they feel is owed to them in a default, there is little or nothing left.

And if you want to identify potential reasons for conflict, armed or not, in the international field, perhaps you should look towards sovereign bonds, debt, default, bankruptcy and restructuring, rather than poison gas. Perhaps that is the "watch the hand" lesson here. The danger lurks, as Joseph Stiglitz said last week at Project Syndicate, in that:

Debt restructurings often entail conflicts among different claimants. That is why, for domestic debt disputes, countries have bankruptcy laws and courts. But there is no such mechanism to adjudicate international debt disputes.

Once upon a time, such contracts were enforced by armed intervention, as Mexico, Venezuela, Egypt, and a host of other countries learned at great cost in the nineteenth and early twentieth centuries. After the Argentine crisis, President George W. Bush's administration vetoed proposals to create a mechanism for sovereign-debt restructuring. As a result, there is not even the pretence of attempting fair and efficient restructurings.

Add to that the presently fast rising yields on (and plummeting values of) sovereign debt (let's use 10-year as a standard) across the board, not just in emerging markets but also among the richest nations, and you have a source for more potential conflicts than you can keep count of.

Let me quote Stiglitz a bit more extensively:

We need a fair system for restructuring sovereign debt

If the debt vultures have their way, there will never be a fresh start for indebted countries - and no one will agree to restructuring

A recent decision by a United States appeals court threatens to upend global sovereign debt markets. It may even lead to the US no longer being viewed as a good place to issue sovereign debt. At the very least, it renders non-viable all debt restructurings under the standard debt contracts. In the process, a basic principle of modern capitalism – that when debtors cannot pay back creditors, a fresh start is needed – has been overturned.

The trouble began a dozen years ago, when Argentina had no choice but to devalue its currency and default on its debt. Under the existing regime, the country had been on a rapid downward spiral of the kind that has now become familiar in Greece and elsewhere in Europe. Unemployment was soaring, and austerity, rather than restoring fiscal balance, simply exacerbated the economic downturn.

Devaluation and debt restructuring worked. In subsequent years, until the global financial crisis erupted in 2008, Argentina's annual GDP growth was 8% or higher, one of the fastest rates in the world. Even former creditors benefited from this rebound. In a highly innovative move, Argentina exchanged old debt for new debt – at about 30 cents on the dollar or a little more – plus a GDP-indexed bond. The more Argentina grew, the more it paid to its former creditors.

Argentina's interests and those of its creditors were thus aligned: both wanted growth. It was the equivalent of a "Chapter 11" restructuring of American corporate debt, in which debt is swapped for equity, with bondholders becoming new shareholders.

[..] Poor countries are typically at a huge disadvantage in bargaining with big multinational lenders, which are usually backed by powerful home-country governments. Often, debtor countries are squeezed so hard for payment that they are bankrupt again after a few years.

Economists applauded Argentina's attempt to avoid this outcome through a deep restructuring accompanied by the GDP-linked bonds. But a few "vulture" funds – most notoriously the hedge fund Elliott Management, headed by the billionaire Paul E. Singer – saw Argentina's travails as an opportunity to make huge profits at the expense of the Argentine people. They bought the old bonds at a fraction of their face value, and then used litigation to try to force Argentina to pay 100 cents on the dollar.

Educational, but we want more. However, keeping in mind that Stiglitz's argument involves but a narrow issue, we should nonetheless recognize that what the US Court Of Appeals has attempted to do is to set a blueprint for future action. We're seeing a lot of these attempts lately. In that vein, the way the Detroit bankruptcy is handled will in all likelihood have profound ramifications for other cities - and states - across the US. And this spring's Cyprus bail-in model will hover over any subsequent troika action in Europe's periphery. Just watch what conditions will be forced upon Greece next spring as it needs yet another credit injection, and Portugal soon after that.

What makes Stiglitz's point relevant is that we will see more sovereign defaults than most of us think we will. Do keep in mind that yields on sovereign debt are rising everywhere. That's not so much a result of bond vigilantes springing into action but of ultra low yields inevitably becoming untenable despite the fantasy notion that central banks can control them. That's what I mean when I say vigilantes and vultures need not apply. They may exacerbate or accelerate the situation, but they are not the reason it comes to pass. It's more like elemental physics. It would all happen anyway. Emerging nations were alright with higher yields than richer nations for a while, because it meant the latter would invest their capital in their riskier paper. But as soon as yields on US Treasuries, UK Gilts and German Bunds started rising, that money left, causing yields on emerging market bonds to rise, but now without the benefit of foreign investment. And that is not just going to hurt, it's going to cause very serious capital issues.

Obviously, in the west yields, though they're inexorably rising, are not terribly high yet compared to historical trends, but that's not the sole meaningful perspective: tons of policies and deals and contracts and what have you have been signed with ultra low yields in mind. And that's where derivatives come into view again, and with them the super-priority principle. What happens next time Spain and Italy see their yields rise above 7%, generally seen as a break-off point? Will Frankfurt and Brussels try the "we'll do anything" line again? Even with yields on Eurozone core debt much higher than the last time they tried that line? I wouldn't bet too much on that one.

Speaking of Europe, in a remarkable preliminary example of where higher yields may lead, there was a curious event last week that I've seen comments on, but without asking the most poignant question. Poland announced that it would take over and cancel all its sovereign bonds held by the private part of its pension system (bonds are about half the private funds' portfolios), much of which is in foreign hands.

Poland to Cancel Bonds From Pension Funds in System Revamp

Poland will take over and cancel government bonds held by its privately managed pension funds, stopping short of fully “nationalizing” the system as it seeks to curb public debt, Prime Minister Donald Tusk said. Pension funds will keep current assets that they invested in stocks and future contributions to the system by Poles will be “voluntary,” Tusk told reporters today in Warsaw.

The government, gearing up for elections in 2015 and trailing the opposition in polls, is seeking to spur recovery in the European Union’s largest eastern economy, which is forecast to expand this year at the weakest pace since at least 1997. The owners of companies running Poland’s pension funds include Aegon, Allianz, MetLife Inc., Aviva, AXA, Assicurazioni Generali, ING Groep and Nordea Bank.

“The privately run pension system is partly built on expanding debt and that has turned out to be very costly,” Tusk told a news conference. “The system’s impact on public debt is crushing and has effectively prevented us from making another civilizational leap.” The shift would reduce public debt by about 8 percentage points, Finance Minister Jacek Rostowski told reporters.

My first question, and the one I missed in comments, was: really? An EU country can just do that? I know Poland is not - yet - in the Eurozone, but it is a member of the EU. And to become that, you have to have a viable economy able to compete with other EU countries, or something along those lines. Public debt is an issue in that. So are pensions systems. And then a government can still simply confiscate half the assets of a pension system, even if it's in the hands of foreign ownership, and replace it with meaningless future debt obligations? Without any scrutiny from Brussels?

Maybe I'm naive, but I wonder what that means for other EU countries, for their public debt, which apparently is subject to simple accounting tricks, and most of all I wonder what it means for the people paying into these systems. If you're in Britain, or even in a Eurozone country, what can you expect your government to do when it no longer approves of the yields on its debt? Are they all going to grab wholesale into their pension systems, create space for another 8% or more rise in public debt, spend it and grab some more? All this without so much as a word out of Brussels? What is Warsaw paying the foreign owners of the system in order to get away with this? And what does that cost their people? Someone has to pay.

In Europe, the situation will be used to push forward the single bank idea and further centralize financial and economic control over the whole Eurozone and wider EU. It will also reboot the pressure on the periphery, and the bail-in model will be unleashed in the Mediterranean until all the millions of Greeks and Portuguese and Italians don't own one single brick in their own nations anymore. Unless they wake up. So one more time, guys: get your countries out of the monetary union! The first to go will get the best conditions. Don't vote for those who want to stay in the union: they seek their own interest, not yours. Pay back your debt in your own new currencies, not the euro or the dollar. Form a Mediterranean union if possible.

In EU core nations, taxes will rise and services cut further in order to pay the interest on public debt. Austerity was just the beginning. Those who stick with the current power cabal will see ongoing talk of an imminent return to growth, along with ever-worsening living conditions, first for the poorer, the old, the weak, than for the middle class and so forth.

In emerging nations, much of the benefit the people in the streets have seen from the temporary rise in investment will vanish into thin air, and yields on sovereign debt will rise above economically viable levels. Nothing all that new for the people perhaps, but dashing new found hope will not be an easy thing; expect new elections multiple times a year, think Argentina. And fast increasing social unrest.

Australia and New Zealand are a bit of an exceptional case perhaps: yield on Australian debt (over 4%) is already higher than Mexico, and New Zealand (4.65%) more even than Columbia. That will not remain the way it is, but both seemingly wealthy nations simply pay more to borrow today than the US and UK (3%), Europe (Germany at 2%, France at 2.6%) and Japan, and will continue to do so as they see their debt payments rise in "harmony" with the "rest of the west". New Zealand even pays more than Italy and Spain at 4.5%. Both also have economies overly dependent on exports (China!) , which makes them overly vulnerable. Not a pretty picture overall.

Japan is a special case, it pays just 0.75% on its 10-year bond today, and that means there is a huge potential for "growth" there. Abenomics is just temp window dressing unless we see a miraculous and double digit recovery in global growth (rising bond yields alone of course make that impossible), and that leads to one conclusion only: a very toxic brew, even without further mayhem emanating from Fukushima. Incidentally, we will inevitably and increasingly hear voices saying Tokyo should be evacuated on account of Fukushima, not host the 2020 Olympics. The billions reserved for the games should of course be spent on a clean-up, but that's not going to happen until Abe is forced to relocate to the reactor area.

And then we're left with the US. Which will be sitting pretty for a while, as Nicole and I have been saying since day one of The Automatic Earth. It's a simple consequence of the Hypothermia analogy I used the other day. In the Roman empire the city itself was the core, which when the system started to hamper began to cut off and bleed dry the periphery. In our present financial system, which in effect runs our world, the core is the US (or more correctly even the core OF the US), and now that that system has started to slow down on its way to a deep freeze, it will call in all liabilities from all over, and what capital remains will increasingly flow to that core. Which in turn means Washington doesn't mind one bit that yields on Treasuries will rise, because it can make the periphery inside America pay for that.

One last thing: all those rising yields will not lead to rising inflation. Rising costs of living, sure, but that's not inflation: the American periphery (here's looking at you, kid) will be bled dry just like European one, and the emerging nation one, and there will be both less money and less incentive to spend, not more. Do keep in mind that last week's jobs numbers included an even greater decrease in labor force participation, which means that America's actual unemployment is much higher than 7.3%, and all those people not spending spell deflation. The system can survive - even if in a zombie state - for a while by simply grabbing ever more from those who have no political power. The few will have more, and all the rest will have less. Less money, less credit, less velocity of money, less inflationary pressure.

We're about to find out that our central banks don't hold the reins of power. And even if they did, they would still not use it for our benefit, they're just branches of the financial system. Which will need our remaining wealth in order to survive another day, and has the clout to take that wealth away from us.

One very last thing: in the Hypothermia article I said:

I've had this - admittedly fully irrational, so I never talked about it - idea for a while that if and when Italian and Spanish 10-year yields turn the same, things will start to take off.

Well, guess what? That's what happened earlier today. Spain's 10-year, the highest of the two over the past few years for obvious reasons, is now even lower than Italy's. So in my intuitive, "fully irrational" world, it's game on, rien ne va plus, all bets are off and gentlemen, start your engines.

By Raul Ilargi Meijer
Website: http://theautomaticearth.com (provides unique analysis of economics, finance, politics and social dynamics in the context of Complexity Theory)

© 2013 Copyright Raul I Meijer - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.
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