Market Dislocations

Tuesday was a very interesting day for the bond markets. Political upheaval within two key European countries, Italy and Spain, caused a dramatic sell-off in sovereign debt across the peripheral European countries. These peripheral countries, which were formally known by the acronym PIGS and include Portugal, Italy, Greece and Spain, saw the yields on their government debt surge as a result of the widespread and relentless selling. At the same time, though, “flight-to-safety” buying pushed yields on the bonds of more fiscally stable countries like the US and German sharply lower. The yield on the 10-year US Treasury bond fell 15 basis points to 2.78% – its lowest level since April 11. The yield on the 10-year German Bund, for its part, fell 8 basis points to 0.26% – its lowest level since mid-2017.
Days like these shine a spotlight on some dramatic dislocations in the global capital markets. For example, how is it possible that Italy – which faces a constitutional crisis, a massive debt load, and questions as to its future in the European monetary union – is a better credit risk than the United States? Is Spain’s government, with all its problems, deserving of an over 100 basis-point discount relative to the US to borrow for 10 years? How does the German government get away with paying only around 0.30% to borrow for 10 years – some 250 basis points lower than the US government? After all, the US economy is growing at a more robust pace than Europe’s. US corporate profitability is soaring (in part due to tax cuts), unemployment is extraordinarily low, and business and consumer confidence is hovering at very high levels. The US has also cleaned up its banking system by requiring its banks to raise capital, limit risk concentrations, and avoid risky business practices. European banks, by contrast, are still highly levered by comparison, with many still heavily exposed to the government debt of the peripheral countries. So why does it cost the US government so much more to borrow?
As with the many other capital-markets dislocations over the past several years, much of the bond-market dislocations can be explained by central bank largesse. Taking the playbook from our Federal Reserve, the European Central Bank (ECB) has been supporting the sovereign debt of its constituent nations through bond purchases. This “Quantitative Easing” has not only supported sovereign bond prices (alternatively suppressed yields), but it has also propped up European banks heavily exposed to those sovereign bonds. In other words, if the ECB were not supporting these bonds, there would likely be no other buyers, at least at prices anywhere near today’s levels. Banks would have to mark their bond holdings to market, which would likely result in serious capital shortfalls. And there would most certainly be another European banking crisis.
Source: Bloomberg
 
There are obviously other explanations for the variance in yields between the US and European government bonds. For instance, the Federal Reserve has long since begun the process of policy normalization by ceasing its bond purchases and raising short-term interest rates. These actions both remove a source of consistent demand for US Treasuries (the Fed) and increase the compensation required to lend to the government on a longer-term base. In addition, the relative strength of the US economy means that inflation is more likely to rise relative to the slower-growing Eurozone. Bond investors need to be compensated for the prospect of higher inflation through higher interest rates. Third, the US government is expected to run large deficits in the future as a result of the recent tax-cut legislation (the “TCJA”) and spending bill. The need to fund these massive deficits and refinance maturing debt will add dramatically to the supply of bonds that need to be absorbed by the market. If supply increases, prices go down and yields go up. Finally, some might also argue that the recent budgetary shortfalls in the US will dramatically increase our debt load, in the process reducing the US government’s credit-worthiness and risking a rating downgrade. While this is true, at least for now this explanation is probably only a very small factor in the recent rise in Treasury yields.
So, notwithstanding all the other possible explanations, you are right to question whether the Spanish, Italian and Portuguese governments, for instance, should be able to borrow at a cheaper rate than the US government. Intuitively, it doesn’t make a whole lot of sense. And while this dislocation could persist long into the future, it’s likely to reverse at some point down the road. But this is just another example of the massive central role that central banks have played in the capital markets over the past 10 or so years. At many times during this period, predicting central bank activity was the most important variable to predict in achieving positive investment results. I’m one investor who is looking forward to the day when that is no longer the case.