Alice: “One can’t believe impossible things.”
The White Queen: “I dare say you haven’t had much practice. Why, sometimes
I’ve believed as many as six impossible things before breakfast.”
- Alice’s Adventures in Wonderland
In Lewis Carroll’s iconic Alice in Wonderland, we are told that believing the impossible takes some practice. The bond market has provided us plenty of practice recently and it appears it will continue to do so for a while to come. While I have mentioned the issues of mispriced risk and negative interest rates in previous communications, I thought it would be helpful to provide some further clarity to the unprecedented dynamic that is currently unfolding in the bond market.
You will recall that following the global financial crisis in 2008 a number of countries in the European Union (EU) were shown to have debt and deficits that were out of line with the terms of their EU membership. In fact, the financial circumstances of these countries were dire and getting worse. In April of 2009, the EU ordered the PIGS (Portugal, Spain, Ireland, and Greece) to reduce their budget deficits and to get “in-line” with EU member fiscal guidelines. By 2010 it was apparent that Greece’s debt to GDP was nearly double that allowed by the EU, and their budget deficit was four-times the EU maximum. Austerity was implemented, and soon there were riots in the streets. Greece has since elected an anti-austerity party and has all but defaulted on the bailout loans provide by the EU. The fate of Greece as an EU member now lies in the hands of the Mr. Draghi and Germany as they carefully consider the precedent-setting and/or potential domino effect of a decision on the fate of Greece. As of now Mr. Draghi and Greece have agreed to extend the time frame for any decisions. The following actual headline appeared in a European paper last Friday and puts things in unique perspective: “Greece – a deal was reached to comply with the old deal, which itself was not an actual deal.”
In 2011, it became apparent that the other three little PIGS (Portugal, Ireland, and Spain) had monumental debt of their own. In fact, without the assistance of the €500 billion European Stability Mechanism these financial-teetering sovereigns would have fallen. The yields on their 10-year debt reflected their precarious financial circumstance with some yields rising above 12%. While they all avoided demise, they all continue to struggle.
Since the days of 2011 when Ireland stood on the financial precipice and its 10-year sovereign yield peaked at above 11%, their GDP has grown at about 2% per year. Their annual deficit stands at 3.7% of GDP, and their government debt to GDP has increased 40% to 123%. In contrast, the US has grown GDP at about 2% per year, the annual budget deficit is at 2.8% of GDP, and government debt to GDP has grown about 7% to 101%. So, here is where we practice the impossible: Ireland’s 10-year bond now yields 0.78% and the 10-year US Treasury yields 1.95%! As we all know, there is no comparing the financial strength and risk profile of the US and Ireland – the above was just a superficial exercise. In fact, there are few sovereigns that come even close to the financial strength, economic diversification, government stability, and overall credit worthiness of the US, least of all the likes of Spain, Portugal, Italy and over a dozen other countries whose 10-year sovereign debt yields are now price-deemed less risky than the US. In the meantime, Janet Yellen’s Fed has removed “patience” from the Fed’s language which now opens the door to US interest rate hikes. Unfortunately, this will likely further distort the current risk-pricing dynamic of the bond market, which only makes sense down the rabbit hole in the land of the impossible.
The impossible doesn’t end with mispriced risk. The concept of negative interest rates is also consistent with the view through Alice’s looking glass. While negative interest rates became a topic of discussion and study in the early days and months of the 2008 financial crisis, the academic debate can actually be traced back to the late 19th century. At that time, Silvio Gesell, a German merchant, theoretical economist, anarchist and vegetarian, first proposed negative interest rates. While Gesell’s “deposit tax” was never widely accepted, it was given some regional consideration during the great depression. Moreover, in the 20th century Gesell’s concept was taken up by no less than John Maynard Keynes, the economist most noted for his belief in monetizing deficits (printing money), a strategy employed by the US for the past 30 years and a derivative of which is Quantitative Easing. While the concept of negative interest rates is very hard to wrap your head around, academics seem to dust off the concept when deflationary pressures become very real.[i]
Indeed, we have gone far beyond dusting off the concept of negative interest rates. In fact, the value of bonds trading at negative interest rates now exceeds €2 trillion and the ECB has just begun its €1 trillion sovereign bond purchase plan. With a mandate that includes buying negative yielding bonds, the ECB purchases will drive the euro value of negative yielding bonds considerably higher and yields even further below the zero bound. To be sure, we are not fighting our father’s inflation; we are fighting our grandfather’s deflation.
The extraordinary interest rate conditions that we see in the bond market today require special consideration. We continue to carefully monitor our fixed income holdings to make sure that our portfolios are well positioned relative to these changing dynamics. Please don’t hesitate to contact us with any questions.
David E. Post
Chief Investment Officer
March 8, 2015
PAST PERFORMANCE IS NOT A GUARANTEE OF FUTURE RESULTS. This market commentary is a matter of opinion and is for informational purposes only. It is not intended as investment advice and does not address or account for individual investor circumstances. Investment decisions should always be made based on the client’s specific financial needs and objectives, goals, time horizon and risk tolerance. The statements contained herein are based solely upon the opinions of Telemus Capital, LLC. All opinions and views constitute our judgments as of the date of writing and are subject to change at any time without notice. Information was obtained from third party sources, which we believe to be reliable, but not guaranteed.