Bond Traders Put Pressure on Debt-Laden Nations
The bond vigilantes are back.
But this time they are roaming mostly through Europe rather than the United States — at least for now. Their mission: to force governments to cut budget deficits that have ballooned in the wake of the financial crisis.
As big investors in the credit markets, activist bond traders developed a fearsome reputation in the early 1990s by pushing up yields on Treasuries in order to force the government to tame large deficits. Their most famous target was a newly elected president, Bill Clinton, whom they pressured to abandon campaign promises of tax cuts.
Today, the bond market posse has set its sights on Europe — particularly Britain and Greece — where stagnant economies and high levels of government spending have led to the highest budget deficits in the region.
Although the left-leaning governments in both countries are struggling to show investors that they have a workable plan to reduce deficits — which now average around 13 percent of gross domestic product — bond traders are increasingly demanding higher interest rates to reflect the rising risks.
Bond traders last week pushed the spreads between Greek 10-year bonds and their benchmark German counterparts — a measure of investor confidence in the country — to highs of 250 basis points after the nation’s credit rating was downgraded, raising concerns over Greece’s ability to service its enormous debt.
In Britain, where the nation’s economy and finances have fallen so sharply that investors fear a possible downgrade of the country’s triple-A rating, bond traders are also taking a hard line. Last week, yields on gilts were pushed to their highest levels since the depths of the financial crisis, after the Labour Party issued a preliminary budget report that skimped on details of spending cuts.
“There is a clear drop in confidence on the part of bond investors,” said Mark Schofield, a fixed-income strategist at Citigroup in London. “I think it is all beginning to unravel.”
The power of the bond trader to influence governments once prompted James Carville, Mr. Clinton’s political strategist at the time, to say that he wished to be reincarnated as one because “you can intimidate everybody.”
Mr. Clinton may not have been intimidated, but he did heed the advice of Robert Rubin, who joined the administration from his post at the top of Goldman Sachs, that a policy of budgetary restraint would keep the bond market happy and interest rates on United States government bonds low.
Since then, the vigilantes have been largely in abeyance: As the global economy boomed, public sector deficits were not a concern for investors.
All that changed rapidly with the onset of the credit crisis last year. Bond traders surfed the global liquidity wave, buying up government debt all over the world in the view that, just as most big banks were too big to fail, so were sovereign economies, no matter how crushing their fiscal picture.
But Dubai World’s recent decision to delay payment on its debt has brought the crisis to reality for complacent bondholders. They have begun to demand that governments with large budget gaps start to pay higher interest rates on their bonds to reflect rising sovereign risk — a development that will lead to higher borrowing costs in countries like Britain, Greece, Ireland and Spain.
The United States and Japan also face unusually high debt levels, deepened by huge stimulus programs. For the time being, investors are still willing to lend to them at generous rates. But bondholders are running out of patience as the finances of even the wealthiest nations spiral downward.
As bond investors become more impatient, some European countries have taken aggressive fiscal action.
In Ireland, the government this month presented the most severe budget in the nation’s history, largely to prove to wary bond investors that it was serious about cutting its own deficit.
“There is a greater market focus now on who the fiscally vulnerable countries are,” said Michael Saunders, the head of European economics at Citigroup.
Britain falls into that category, he said, because the British Labour government, led by Prime Minister Gordon Brown, is facing a difficult election battle and appears more concerned with pleasing voters than investors. That could lead to a bond market rout if gilt holders, a large proportion of them foreign, come to the conclusion that cutting the deficit is not a top priority, he said.
In the euro zone, the European Central Bank’s interest in keeping inflation low means that it is likely to maintain a stable euro, leaving smaller European economies with no opportunity for a cheaper currency to help generate growth from exports.
As a result, governments in Portugal, Ireland, Greece and Spain have had to turn to increasingly skeptical bond markets to raise funds while waiting for their economies to recover through the far more painful process of squeezing wages and shedding jobs to restore competitiveness.
A recent report from Standard Chartered even suggested that weak euro members like Greece and Ireland might reconsider their ties to the union if investors pulled the plug and stopped refinancing their countries’ debts.
“The idea that currency unions can’t break up is rubbish,” said Tim Congdon, an economist and professed euro skeptic who has advised Conservative governments in Britain. “The critical issue is whether governments can repay their debts in new currencies or euros once they leave.”
If they can pay back bond investors in new and cheaper currencies, then it is in the interests of countries like Greece to go out on their own, Mr. Congdon said.
But with other countries seeking the shelter of the euro and leaders like Angela Merkel of Germany hinting that the big powers would come to the rescue of Greece and other distressed countries if necessary, most economists argue that the euro zone is unlikely to crack.
Still, that has not stopped bond investors from talking up a new divergence trade in Europe — the flip side to the convergence trade earlier this decade, during which Irish, Greek and Spanish government bonds were bought on the theory that a grand economic harmony would sweep Europe.