It’s a question of bonds

4

For those who spend sleepless nights fretting about the sustainability of the massive sovereign debts amongst the largest economies of the world, it must seem rather incongruous that bond yields are plunging to new record lows at the same time. In the UK, where the overall debt burden (including not just that of the UK government but also the household, finance and corporate sectors) totals more than 400% of GDP, the 10yr gilt yield dropped by a further 12bp yesterday to just 2.43%.

To put this into context, the last time long-dated gilt yields were at these levels was 1946. In the US, where fiscal policy is still in disarray (notwithstanding the recent deal to raise the debt ceiling) and the S&P recently lowered America’s AAA credit rating by a notch, the 10yr yield is now just 2.15%, after almost reaching 2.0% last week. In the past month, the yield on the 10yr Treasury note has fallen by almost 100bp. Only at the height of the global financial crisis at the back end of 2008 and early 2009 did we see yields down at these levels. And in Japan, where government debt represents 200% of GDP, the 10yr yield is just 1%. The debt load of many of these large developed economies may look incredibly challenging, but investors are not yet punishing these governments, in large part because prospective returns from most other asset classes do not look attractive.

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Commentary

Sterling safe-haven story waning. The minutes of the August MPC meeting showed all nine members voted for keeping rates steady, which is the first time we’ve seen this convergence of views since May 2010. Given the recent data, combined with developments in the global economy, the shift was not that much of a surprise. It would have been more surprising to see both members (Dale and Weale) sticking to their guns and continuing to vote for higher rates. At the same time, Posen still voted for more QE and with a hint of schadenfreude as “some members considered whether there was a case for increasing the degree of monetary stimulus by undertaking a further programme of asset purchases”. But what should be stressed is the high level of uncertainty around their views generally. It’s far from the case that we are on a linear path to more QE. The other point of note is the latest labour market data showing a push higher in both the claimant count and also the wider ILO measure of unemployment. The latter moved from 7.7% in May to 7.9% in June. So far, the data are telling us that the private sector (at least up to March) is more than compensating for job losses in the public sector (by a factor of four times), although whether this remains the case is yet to be seen later this year as both will be moving in the wrong direction. The data and the minutes have reinforced the view that regardless of an anticipated rise in headline inflation to over 5% in coming months, a rate increase can’t really be contemplated whilst the economy has essentially stalled. The continued talk regarding QE2 will mean that sterling will struggle to position itself as a safe-haven from the eurozone storm.

Merkel & Sarkozy meeting a major disappointment. Agreement on the issuance of Eurobonds was never a likely outcome of Tuesday’s meeting between Angela Merkel and Nicolas Sarkozy, but there was a reasonable expectation that both would take more concrete steps towards endorsing the need for a fiscal union in Europe. With respect to the latter, unfortunately very little of substance seems to have emerged. Merkel and Sarkozy claimed to support the idea of “real economic government” for Europe, headed by current EC President Van Rompuy, to meet at least twice a year. How different this proposal is to the current situation is not exactly clear. There was also a call for national governments to insert balanced-budget legislation into their constitutions, rather than just into national legislation as per the current proposal. A good idea and not to be discouraged, but to be frank the Stability Pact was supposed to achieve this same fiscal objective but was never properly enforced. The only new development to come out of the meeting was a commitment by France and Germany to co-ordinate the economic forecasts underlying their budget planning (hardly a big deal), and a vow to consider a common corporate tax rate across Europe (one of Sarkozy’s policy pre-occupations). Both Merkel and Sarkozy must recognise, at least in private that the euro needs some form of proper fiscal union or else it is doomed in its current form. They are unlikely to be given too much more time by the markets to put this together. Unless investors and traders are convinced that Northern Europe can properly contain and control the eurozone’s fiscal miscreants, then the former will continue to batter the bonds of the latter. The situation is now binary. Whatever the political and legal risks, Merkel and Sarkozy must push for proper fiscal union as a prelude to the issuance of Eurobonds. Without it, most of Europe’s highly indebted economies will be forced to leave the euro.

SNB balks at introducing currency peg. Those rumours circulating over recent days that the Swiss National Bank was set to announce a currency peg against the euro were dashed by yesterday’s announcement. The SNB has vowed to raise banks’ sight deposits from CHF 120bln to CHF 200bln immediately by purchasing outstanding SNB bills and employing FX swaps. Remarking that the Swiss franc remains “massively overvalued”, the SNB promised to “take further measures” – if necessary – to prevent further strength in the currency. In response to the lack of a currency peg, Swiss franc shorts against both the dollar and the euro were forced to cover – the Swissie fell from above 0.80 to 0.7880 at one stage, while EUR/CHF dropped from above 1.15 to below 1.13. However, these losses were reversed over the course of the day, and the Swissie is now back near 0.7950. Separately, one of Switzerland’s major newspapers reported that the government will provide CHF 1.3bln of financial aid to businesses battered by the strong exchange rate. The Swiss cabinet met yesterday to discuss the package.

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