Bond Markets, Greece, The Fed & The ECB
April 28, 2010
David R. Kotok, Cumberland Advisors
The shock from Greek debt pricing and credit rating agency downgrades of Greece and Portugal has caused a flight to quality among sovereign debt issues. There is now a great divide between high-grade and junk. Junk status debt trades with double digit yields. Those markets have been rendered non-functional.
High-grade sovereign debt like US treasuries, German bunds and Japanese JGBs have rallied to low yields. Other high-grade global credits have followed. The spread between low-grade and high-grade sovereigns is measured in hundreds of basis points. It used to be in tens of basis points.
This debt crisis, like every other in the history of modern finance, will eventually be resolved with a restructuring and change in the debt regime of the sovereign state that issued debt with profligacy. Greece will pay a hefty price for its failure to control its budget. Other states are watching and learning. Ireland, Latvia and Uruguay are examples of states which changed their behavior with success. Argentina is an example of failure of government; it still cannot access the world’s capital markets. In the US, New Jersey is an example of a state which is trying. Illinois is still struggling. Michigan’s policy hasn’t changed enough but hopeful signs are emerging. California can no longer claim that its credit rating is the same as Greece; Greece is now lower.
Meanwhile all this has implications for US monetary policy which is why there will be no change in the Fed Funds Rate announced today and why the Fed is likely to continue its extended period language and keep short-term interest rates low for the rest of this year.
Debt crises injure the credit mechanisms. They cause the credit multiplier to contract. They instill fear and thus psychologically damage the market agents who deal in them. All this comes at the same time the US financial reform bill is advancing and the Goldman, Paulson Tourre affair has dominated the news of the world’s largest debt issuer and in the world’s largest debt market. The US is getting a temporary respite and that reflects in the rallying treasury yields.
One open issue is to be determined. Will the Europeans sacrifice a half century work by undermining the euro? There is where the global rubber now hits the road. The euro had the makings of becoming the world’s second reserve currency. It had reached a level of about 25% of world reserves. The dollar was down to 65%. All others and their gold hoards totaled about 10%.
If the European Central Bank (ECB) uses its printing press to bailout Greece, it will permanently open itself up to global distrust. In order to avoid that, it must allow risk of a member bank’s holdings of Greek debt to evolve and that means there may be losses. Otherwise, the euro will be undermined by the very central bank that was created to avoid such an outcome.
The euro took a thousand years to create. After a millennium of killing each other, the Germans and the French decided to set aside war and advance the notion of an economic union, open trade and transparent borders. Travel, commerce and finance between Berlin and Paris has never been easier than today. Undoing this good work is the risk that the ECB will take if it undermines the strength of the euro by making a disastrous policy error.
These decisions are now in the hands of the ECB governing council. Unlike the US Federal Reserve, the central bank in the euro zone is protected by a treaty and may act independently of the pressures put on it from any single sovereign state. Their single mission is to preserve the value of the euro and the steadiness and predictability of the monetary policy. The world now watches.
We exited our strong euro position months ago. Whew! We are only carefully selecting country exposure in our European ETFs strategy. Our colleague Bill Witherell is drafting a piece about this now and it will be released soon.
We have raised cash and are patiently waiting before we redeploy it into markets. This is a fascinating and challenging time to be a money manager with stewardship over billions of separate accounts. The goal is to preserve the capital of the clients as the events unfold and to deploy them in the areas where we can be most opportunistic.
David R. Kotok, Chairman & Chief Investment Officer, Cumberland Advisors, www.cumber.com
Resources:
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