Sovereign Debt Issuance to Speed Up, at Europe's Peril
The pressure on governments to fund bailouts and spend to reinvigorate their economies has led to a sharp increase in the issuance of sovereign debt.
Falling inflation, rising unemployment, and trillions in bond purchases by central banks have all helped keep Treasury yields near historic lows. The large amount of bond issuance has already impacted market.
This week, the Libor (the London Interbank Offered Rate) – the rate where banks led to each other -- hit a 10-month high as investors lost some confidence in the smooth functioning of the banking system.
Unlike the 1980s, when "bond vigilantes" sold bonds due to inflation concerns, investors today are anxious about massive budget deficits and the amount of bond issuance needed to finance them.
The risk is that if bond buyers lose interest, governments could find themselves in a situation where rates and inflation spiral out of control.
But experts told CNBC governments would likely keep going to the sovereign debt well, especially this year, exacerbating the already precarious position of many national balance sheets.
"The aftermath of the financial crisis is poised to bring a simmering fiscal problem in industrial economies to the boiling point," Bank of International Settlements Chief Economist Stephen Cecchetti said in a research paper, “The Future of Public Debt: Prospects and Implications.”
“The Keynesians were right, spending leads to growth," Tim Scala, macrostrategist at Sophis Investments, said. "The problem is our government borrows to spend. We’ve been issuing 20- and 30-year debt, conveniently, so the citizens don’t have to deal with it now."
Growing Your Way Out Isn't Working
In previous economic downturns, governments have been able to grow their way out of fiscal indebtedness.
But according to James Bevan, chief investment officer at CCLA Investments, several factors are hindering growth this time, including the international reach of the financial crisis, high private-sector indebtedness, the loss of capital controls (making it harder for central banks to inflate away the debt,) the degree of unfunded liabilities (estimates these to be above 400 percent of gross domestic product in Europe); and the aging population.
As a result, governments are being forced to borrow. The pace of sovereign debt issuance has accelerated in 2010 -- and is set to intensify.
"We’re going to get a flood of issuance this year,” Elizabeth Fell, fixed income strategist at Barclays Wealth, said.
"We’re in environment now where the government drives the process," Scala said. "They will need to reduce debt issuance (at some point). This is a concern to because debt has stimulated economy up until now."
You Can’t Buy Your Own Debt Forever
If the demand for sovereign paper fails to keep up with supply, Scala forecasts significantly lower growth globally, adding that "there’s no corners of the world who won’t feel it."
Economies can experience government bond funding problem when there is a sharp pick up in demand for private-sector credit, according to Bevan.
"I would expect there to be a 20 percent to 30 percent correction in equities once demand for private-sector credit returns and this in turn would prompt a government bond funding crisis," Bevan said.
The risk is an abrupt rise in government bond yields as investors choke on excess public debt. “We believe that bond yields are likely to rise another 20 to 40 (basis points) from here,” Bevan said.
Fell agreed, saying "the world won’t accept low, low rates." "The (Federal Reserve) and (European Central Bank) are buying bonds at dizzying pace," Scala said.
"We’ll have a slowdown, lower rates, and higher bond prices. In that context, governments will issue even more debt and stimulus packages to pay for. Governments are now buying their own debt.”
Scala compared near-$1 trillion bailout programs, followed by bond purchases, as similar to “what Enron did back in 2000 – have one entity buying, the other selling. The sovereign governments cannot buy their own debt forever."
“Look at what’s happening to currencies and gold," he said. "Investors are uncomfortable with the quantitative easing factor. Why is gold at $1,200/oz? Drastic austerity measures will be needed to head off a compound interest spiral, if it is not already too late."
Still Bargains to Be Had?
But investors shouldn't write off government bonds completely. Now may be the perfect opportunity to snap up sovereign debt bargains.
"We would have our clients avoid PIIGS (Portugal, Italy, Ireland, Greece and Spain) for less-stressed economies like France and Germany,” Fell said.
She added, “Canadian debt is solid, as well as Switzerland, Australia and Scandinavia.”
"In order for investors to be worse off in bonds than in cash, bond yields in the US would need to rise beyond 4.4 percent,” Bevan said.
Living in Denial
While it seems governments are faced with bad and worse choices regarding debt issuance, experts said that, if the pace is turned down significantly, citizens of many advanced economies will get a harsh reality check.
"The question is when markets will start putting pressure on governments, not if," Cecchetti said. "When will investors start demanding a much higher compensation for holding increasingly large amounts of public debt?”
Citizens accustomed to receiving the fruits of government borrowing will be forced to recalibrate their living standards, something that has not happened as of yet.
“The essence of the Greek protests is the feeling (of) ‘our government sold us down the river,'" Scala said.
"Everyone’s been living in denial. When you take away the government’s ability to issue debt, you’re taking away their ability to grow.”
"The EU bailout was incredibly dramatic,” Fell said. "It’s scary that people don’t agree with what economists have recommended," she added, speaking about Greece.
"The rest of the world says 'you have to do this,' but it must feel awful to be on the receiving end of these austerity measures." "Austerity packages are simply not palatable for the masses," Scala said.
"Citizens have to embrace the deal. Most of the conversations were had by government officials, who then shove these packages down the throats of citizens."
Can governments do anything to soften the blow?
“Stop telling them that you can put 10 pounds of silver in a 5 pound bag. They need to be honest with the electorate,” Scala said.