(republished from “A View from the Trenches“,Â September 16th, 2012)
Click here to read this article in pdf format:Â September 16 2012
Last week, after the German Bundesverfassungsgericht decided not deactivate the debt monetization program announced by Mr. Draghi a week earlier, the Italian government sold EUR4BN in 4.75% 2014 notes at an average yield of 2.75%. This compares with 4.65% obtained at a sale of the securities on July 13th.
With the European Central Bank backstopping short-term EU sovereign debt (as long as the issuer submits to a fiscal adjustment program), we should see two trends taking place:
The first one, mentioned inÂ our last letter, is that the market should arbitrage between the rates of core Europe and its periphery, converging into a single Euro zone target yield. The Italian auction mentioned above, together with continuous weakness in Germanyâ€™s sovereign debt, the movement of capital out of the US dollar to the Euro zone (lifting the Euro to $1.31) and the rally in EU banks, would seem to indicate that this convergence is slowly materializing.Â The critical piece here, the one that will really nail this coffin, is the return of deposits transferred to the core of the Euro zone, back to the periphery that originated them. This is whatâ€™s behind the ongoing negotiations towards a banking union.Â Ironically, if the banking union was successful, making deposits return to banks of the periphery, it would make it easier for the Germans to leave the Euro zone,Â because the current imbalances of theÂ Target 2 systemÂ would disappear, radically lowering the cost of the exit!
The second trend, the one we missed last week, consists in that â€“perhaps- we will no longer be able to talk about â€œtheâ€ risk-free rate of interest, when we refer to the US sovereign yield. If the first trend proves true, there would be no reason to believe that the short-term US sovereign yield should keep as low as it is vs. the equivalent EU sovereign yield.Â For all practical purposes, in the segment of up-to-3 years, the European Central Bank would set the value of the worldâ€™s risk-free rate! The big assumption here is of course, that the first trend, above, holds true.Â Only then, the arbitrage between the US sovereign yield and the EU sovereign yield could be triggered.
What would the levels be, for the up-to-3 year yields? As we know, the European Central Bank will not pre-commit to a yield target. Of course, they donâ€™t want to be challenged, because there is only so much they can sterilize before they start suffering a net interest loss, as we explainedÂ last week. But from a dynamic perspective, what counts is not the level, but the driver: In the long run, as the sterilization fails (also explained in our last letter and first proposed back onÂ May 13th, 2010), the short-term â€œrisk-freeâ€ rate of interest would be driven by the consolidated fiscal deficit of the Euro zone.
Having said this, the remaining question is what determines the value of the long-term risk-free rate of interest. The Fed, in our view,Â although not announced last Thursday, will eventually continue to purchase long-term US sovereign debt. Effectively in the beginning, the Fed would set the value of the risk-free yield curve, past the three-year point. When things get out of control and inflation expectations for the US dollar take the lead (in a few years), the fiscal deficit of the US should determine the dynamics of the long-end of the curveâ€¦.Does that make sense? No! (At least not, if you are not Keynesian)Â Because if â€œthings get out of controlâ€, we must say good bye to long-term interest rates altogether.Â That market will evaporate, and the US will only be able to sell short-term debt. At that point, if the Euro zone still exists as we know it, the battle for the ownership of the risk free rate will have been won by the European Central Bank, by definition. Why? Because by definition, if the Euro zone still exists, it is because they succeeded in stabilizing their fiscal problems. Otherwise, the shortening of the term horizon for the US sovereign yield should continue contracting, until hyperinflation completely wipes it out.
With these thoughts in mind, one cannot but wonder at theÂ idiocyÂ blindness of those who sustain that both the European and the US central banks removed â€œtail risksâ€ in the last days, with their new measures. To start, the whole idea that a tail risk exists is simply a fallacy of Keynesian economics. It assumes there is a universe of possible outcomes and, as if humans acted driven by animal spirits, randomly, each one of them has a likelihood of occurring. In all honestyâ€¦.what else can occur if a central bank prints money to generate a bubble? Why would the bursting of the bubble be called a tail risk, rather than the logical outcome? Why, if that was tried in 2001 in the US, resulting in the crisis of 2008â€¦why would it be any different now, when there is an explicit announcement to print billions per month? Why?
The splitting of the risk-free interest rates, in short and long terms,Â and the â€œmovingâ€ of the short-term to the Euro zone somehow sadly reminds us of the division of the Roman Empire, between West and East, when the capital moved to Constantinople. Is this ominous?
Finally, as inflation expectations, post the ECB/Fed announcements pick up, the rally in credit (i.e. IG18 credit default swaps index reaching 83bps) is telling us that banks outside the Euro zone or the USD zone -banks which did not benefit so much from a â€œportfolioâ€ effect-, will have a hard time remaining profitable, unless they take additional risks, or they get themselves the same subsidy that the ECB and the Fed give to their zombie banks. This suggests to us that the Canadian dollar should not rise significantly above the US dollar.