Crossing the Rubicon – I

For the last month or so investors have been running away from government bonds, namely the long term ones, as an appreciation of what everybody knew but was afraid to say out loud: that these do not provide adequate compensation for an investment at such maturities or, to put it bluntly, they yield negative real rates.

The South of Europe is a noteworthy exception to this trend as it becomes clearer in peoples’ minds that the European Fiscal Union (a building block of the European Union of the Soviet Socialist Republics or EUSSR) draws nearer. A European 10 year bond at just under 5%, even if issued by the otherwise financially broken government in Madrid, seems indeed an attractive deal. This is why this trend is easier to perceive in the German Bund, where the price movement is more pronounced.

Please bear in mind that the only reason why people even consdered to hold on to most long-term government bonds knowingly was because they presented an unique opportunity to perceive a slightly better return within a near-flat yielding market while a fast exit, if things got tricky, was (is) in place with central bank’s policy of outright buying them or, at least, allowing them to be used as collateral for immediate cash.

Now, the object of any type of debt (credit) is the exchange of present goods for future goods and the difference in quantity between what is received (delivered) at the beginning and what is paid (received) at later stages is what we call interest. In a recessive and deleveraging environment, the pool of goods that will be available in the future is perceived as diminishing and thus people, if not happy, at least resign to settle for a smaller amount of those goods. Especially if that means they can keep their principal more or less intact. Government bonds have thus been seen as the preferred vehicle. Most private companies depend on making things right to earn a profit and pay back its creditors and stockholders, while government has the power, and resorts, to exact private wealth to compensate its own. After all, nobody really expects governments to invest profitably when purchasing bonds. So, does this shift mean the tables are turning and the quest for higher yet more uncertain yields means the world economy is moving out of the recession? Not so fast.

Nobody likes to spoil a good party (well almost nobody) but the problem here, to all those who are moving into privately issued assets, is that there is no magic wand to turn the economy around and the fact remains that a lot of companies look attractive simply because their assets are only so valued in a low interest rates environment. If investors demand additional compensation because of rising interest rates they will find out there is little or none to be given. This probably explains why, for the time being, there is a preference for investing in corporate debt over equity and the selling of government bonds is mostly done on longer-term maturities, knowing that no central bank will dare to increase rates. Anyway, what is commonly known as “risk premiums” for these assets must come down in order for the investment strategy to pay off. For the time being the stronger demand for these assets makes sure this is so and draws more people into it (which is ultimately what “risk premiums” are all about, they tautologically go down as the number of people who wish to hold or acquire a given asset increases).

On the other hand governments seeing funding costs rising, investors who cannot get out of government bonds (because laws require them to hold significant ammounts that type of assets) and the Chinese in case they are not the ones doing the selling, will not be pleased. Although this movement is bounded by the low productivity imposed upon the private sector (ironically partly due to the increased amount of taxes required to service the expanding public debt and the lack of freedom imposed by tighter regulations over businesses) it can draw a lot of blood.

The moral of this story might just as well be: when there is not enough wealth around, little is produced, and capital is being destroyed, preservation depends upon antecipating where the next lifeboard is and swim there first. Then make sure to get out on time as it gets crowded. A cynic might argue that it is always like that when it comes to financial markets. But, in this case, cynics are wrong.

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