In June 2012, at a time when central banks had pushed interest rates to almost zero, Italy had to borrow at 8% to re-finance its gargantuan $3 trillion debt. Spain was in even direr straits. With national income falling by 2% annually, these interest rates meant that the national debt mountain was rising by 10% every year. In one word, insolvency! This was the spectre hanging over major European nations in the summer of 2012, guaranteeing that the Eurozone was finished. Today, Italy’s and Spain’s interest rates have fallen to a more manageable 3% to 4% and national income has stabilized. There is even fast money that flows into the crippled European banks, even into the dismembered Greek stock exchange, seeking bargain-basement prices for certain woefully depressed shares. These observations can easily be mistaken for signs of light at the end of the tunnel. But ‘mistaken’ is the operative word.
Stabilized public finances, continuing economic and social disintegration
Europe’s apparent ‘stabilization’ can be pinned down to two factors. The first, and most crucial, was the ECB’s intervention in the summer of 2012. Moments before the Eurozone blew up, with devastating impact upon the rest of the world, the ECB stepped in with its nuclear option, also known as the OMT Phantom Program (OMT standing for Outright Monetary Transactions and ‘phantom’ because it has not been activated, so far): ECB President, Mr. Mario Draghi, former Goldman Sachs and Bank of Italy golden boy, issued a stern warning to bond dealers the world over: “Bet against Italy and Spain and I shall blast you out of the water. I shall print as many euros as I need in order to buy as many Spanish and Italian bonds as necessary to bury you in your filthy bets.”
Of course, these were not his chosen words. But they there the words that bonds dealers knew he meant to convey to them. They also knew that Mr. Draghi had issued that threat contrary to his own charter. At that point they could have called his bluff. Instead, they chose to back off and stopped short-selling Eurozone government bonds (most likely because Chancellor Merkel had backed Mr. Draghi, via Mr. Asmussen). So far, bond markets seem happy to remain cowed by Super Mario’s bravado and not to test the OMT threat.
The second factor took longer to play out. It was a large transfer of wealth from the taxpayers to the banks and from the weaker citizens to the states’ coffers; a transfer that was predicated upon immense cuts in wages, salaries, public sector jobs, unheard of tax hikes and the effective demolition of social security. In words, austerity of a magnitude that put the patient into an induced coma. By 2012, the Eurozone was in a triple-dip recession which reduced projected growth and created deflationary expectations (which are currently being confirmed) that increased the attraction of high yielding bonds, especially under the aegis of Mr. Draghi’s OMT pronouncement.
With these two moves, the tail-spinning Eurozone was forced into a temporarily stable rut. Most governments became a shadow of their former self while Europe turned a blind eye to the insolvency of the banks that continued to operate without really lending to anyone. As government spending shrunk, along with the services to their citizens, and taxes rose, speculative investors (e.g. hedge funds desperate for returns a smidgeon above the almost zero interest rates available elsewhere) suddenly decided to take another look at the possibility of unloading their idle cash onto Europe’s governments. After all, had Mr. Draghi’s ECB not promised to keep these governments solvent?
Coupled with the German Chancellor’s belated statement, in the Fall of 2012, that even pathetic Greece would be kept within the fold, the ECB’s move and Europe’s induced coma turned the tide: Private money began to trickle back to Europe in the form of cheap loans to Europe’s governments and bets in their stock exchanges.
A semblance of recovery had taken root. If not in the real economy at least in the domain of public finance and in the realm of speculative capital. The appearance of an upturn was reinforced further by the simple fact that the European Commission and the national governments, having panicked at the political consequences of their austerity drive, stopped pushing for more of it. While they never dared admit it had been self-defeating, and did nothing to reverse austerity’s deleterious effects, they did give up on their initial plans to impose even deeper austerity in 2013. In short, Europe’s bond markets have stabilized due to the combination of the ECB’s OMT announcement, the rise of deflationary expectations due to the austerity-induced recession, the cancellation of further austerity post-2012 and, lastly, the decision to keep Greece in the Eurozone.
Capital inflows into bond markets and the changing behaviour of bond dealers
While it is clear that Mr. Draghi’s OMT threat worked because the bond markets did not test it, it is unclear why the bond markets showed no interest in testing it. Their deflationary expectations (which increased their attraction to government bonds) played an important role, as did the common belief that the ECB would not allow the Periphery to default again (after Greece’s PSI). Still, there is a lacuna of explanation as to the radical absence of any bond dealer interest in challenging Mr. Draghi. I shall argue below that this lacuna disappears if we take a broader look at the global bond markets.
Morningstar, the US based investment research group, reported recently that, since 2009, $700 billion additional funds were placed into US bond funds by US investors alone. This wall of money, which exceeded even the influx of capital in the dot.com bubble economy in the late 1990s, has, since then, appreciated (as bond prices picked up) to almost $2 trillion. In parallel to these developments in the United States, and perhaps because of them, another $1.2 trillion rushed into bond funds outside the US, especially in 2012. (To put this into perspective, during the same period, only $132 billion net went into the world’s stock markets.) Much of that money moved toward the Eurozone following Mr. Draghi’s OMT announcement.
A recent research paper from the Chicago Booth Business School asks poignant questions about this footloose $3.2 trillion that is slushing around the US and European bond markets. Its conclusion is that we should expect a great deal more volatility and herd behaviour of these bond funds than before. “Investing agents are averse to being the last one into a trade [that] can potentially set off a race among investors to join a sell-off in a race to avoid being left behind,” the paper suggests. Is this not a problem with all fund managers? No, according to the Chicago Business School researchers who argue that bond fund managers have become more fickle than equity dealers. “Delegated investors such as fund managers are concerned with relative performance compared to their peers because it affects their asset-gathering capabilities…”
Analyzing how bond funds reacted to the news that the Fed was about to ‘taper,’ the Chicago paper surmises that bond fund managers are faster to hit the ‘sell’ button than banks (that used to hold a larger portion of bonds) ever were. One reason for their jerkiness is that hedge funds have been upset, of recent, by the failure of strategies that used to re-pay them handsomely. Funds used to take it for granted that interest rates and exchange rates followed some predictable patterns depending on the trends of global capitalism. Since 2011 these patterns have shattered and the hedge funds have suffered. Their reaction to the collapse of their modeling ‘certainties’ was that they fell back on simple strategies, such as heading, herd-like, toward high yielding (in real terms) Spanish, Italian, even Portuguese and Irish debt – ready to assume that, while these Eurozone countries are to all intents and purposes insolvent, their bonds are the best of a bad bunch of investment choices.
Michael Hintze, chief executive and founder of European hedge funds CQS, was reported by the Financial Times to have argued that desperate central bank policies (such as the ECB’s) have actually increased market risk. They did this by causing too much money to flow into the same assets, essentially ‘rigging the market.’ When this happens, a small flight from a certain asset class can lead to catastrophic declines. In the Eurozone’s case, where the ‘asset class,’ and ‘rigged market,’ in question concerns none other than the bonds of fiscally stressed sovereigns, the abrupt declines will take Europe back to its pre-June 2012 situation. Only that, when this happens, Europe’s real economies will be even more fragile and the ECB decisively neutered (especially after the recent decision by the German Constitutional Court to admonish OMT and refer it to the European Court of Justice).
Peripheral bond debt-to GDP ratios are, today, much higher than they were in June 2012 while nominal national income is, more or less, the same and lacks any genuine growth potential. So, why have the bond yields of the Periphery’s member-states fallen so much since then?
My answer, in brief, was: They declined because of: the ECB’s OMT announcement, the rise of deflationary expectations due to the austerity-induced recession, the cancellation of further austerity post-2012, the decision to keep Greece in the Eurozone, and a large inflow of capital into the bond markets that has taken a form which makes a large, sudden outflow very likely. Taken together, these six causes point to a disturbing prediction: Europe has not stabilized. While its bond markets have calmed down, the Euro Crisis is taking a breather before it returns with a vengeance.