Relevant and even prescient commentary on news, politics and the economy.

Is This A Bad Thing? Sane Economists would say No.

Yes, I’m working with the null set again, but Peter Bockvar, chez Ritholtz, raises the most common objection to the Greek restructuring’s likely effect on the CDS market:

[I]t will…potentially destroy [the sovereign CDS] market to the point where it will go away. The unintended consequence of what will be next will be those looking to hedge sovereign exposure, mostly banks, will then have to short sovereign debt or outright cut credit to the region. EU officials better be careful what they wish for the holders of Greek CDS.

The English translation of this is that Mr. Bockvar suggests—I can’t swear that he believes, though I know which way to bet—that the current prices for sovereign debt are artificially high because of the existence of the Sovereign Debt CDS market.

So, unless you are trading acvtively in both markets, as a buyer, you are being charged too much for sovereign debt.

Wouldn’t it be better to know that up front?

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Europe’s at it again…

Key European CDS are starting to turn in the more northern direction again, as the German-French ‘pact for competitiveness’ faces near-unanimous pushback across Europe.

Credit default swaps (CDS) are a market security used by investors to buy 5-yr protection (in this case) against default (or the like). As the spread rises the implied probability of default does too. Current market values imply a 39% probability of default by the Irish sovereign (listed in legend), 20% by that of Spain, and 14% by the Italian sovereign, etc. Cash bond spreads are blowing out again, too, where Spain now must pay a 216 bps premium over Germany on a 10-yr loan (the sovereign bond). I’d say that’s not totally irrational.

I completely understand why these negotiations are stalling. I’m Spain – it’s not clear that Spain commented against the pact based on this article, but I digress – why would I agree to a deal that forces more ‘competitive’ measures, which really just means quashing indexed wage growh, reducing the government deficit, adhering to a fiscal policy rule (which, by the way should be modeled after Germany’s debt brake), and adopting a standardized tax rate? Okay, I will if you (Germany) will. Meaning, I’ll increase my competitiveness by stripping away aggregate demand if you allow prices to rise. I’m Germany – no way. (Please see my previous post which argues that a successful transition to a more stable Eurozone depends on higher Germany inflation.)

Der Spiegel spells it out pretty succinctly in an article that is now two weeks old but still totally relevant:

Germany will only agree to additional guarantees for the euro rescue fund — as the Commission and other parties have called for — if its partners approve its competitiveness pact.


Simply put: we (Germany) will only agree to eventually bail you out if you agree to our harsh demands at that time, or you agree to our harsh demands now. You’re choice.

This political drama is far from over. (More exciting analysis below the jump)

(Dan here…Kantoos responds to Rebecca…http://kantoos.wordpress.com/2011/02/15/rebecca-wilder-on-eurozone-monetary-policy-and-german-inflation/ )

Here’s another little fact to think about: The price to buy protection against a default by the Japanese sovereign is just 77 bps, that’s only 23 bps above that for the German sovereign. This is ironic because Germany is the premiere demander of fiscal austerity, while Japan is not (to say the least) with gross debt equal to 221% of GDP (according to the IMF) – or is it?

The table below lists common characteristics usually associated with rising CDS spreads (CDS spreads are current as of 4pm today and may vary according to pricing source): the stock of debt held by foreigners (any currency denomination) and the stock of gross public debt. The final column illustrates the ability of a country to print fiat currency that is not backed by anything but government decree.

I think it’s pretty clear: Japan and the US have very elevated government debt, but low external holdings AND can print their own money to finance liabilities (which by the way are in most part denominated in their respective currencies). Clearly markets’ attach weight to this simple fact via low CDS spreads.


To be continued….

Rebecca Wilder

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According to bond markets, Ireland is not yet Greece

A few articles regarding the bond crisis in Ireland:

The Irish Mess (IV)
ECB buying of Irish bonds ‘vital’ support
The world backs away from Ireland, Spain, Portugal
In keeping with Halloween, here’s a scary one
EU leaders trigger another bond market crisis
Ireland fifth best place to live (a separate issue, of course)

Yves Smith’s article (first link) is good, providing a network of associated links including one to Ambrose Evans-Pritchard. He states the following:

Yes, Ireland is fully-funded until April – and has another €12bn in pension reserves that could be tapped in extremis – but that is less reassuring than it looks. The spreads over German Bunds are mimicking the action seen in Greece in the final hours before the dam broke.

Ambrose Evans-Pritchard’s article is well worth a read; but I’d like to talk about bond markets for just a bit. Yes, the probability of Irish default is increasingly being priced into bond markets; however, Irish bond market conditions have not yet reached those of Greece in May 2010 (the bailout announcement), nor are they really close…yet.

The Irish yield curve (proxied by the 10-year government bond yield minus the 3-year government bond yield, now the 3-10) is still positively sloped. (I choose the 3-10 because of the ESFS that is in place through 2013.)

This is important. See, when there is a binary outcome being priced into a sovereign bond market, default or no default, investors go straight to the long end of the term structure, and the yield curve inverts (negative slope). In a default situation, the longer end of the curve offers a higher expected return where the potential yield compression is much larger. That’s what happened in Greece in May 2010, as the 10-yr bond yield reached 12.4% on May 7.

The two yield curves look “similar”; but Greece’s yield curve turned negative, or near -500 basis points (bps) inverted – a basis point is the % * 100 – preceding the bailout. At the time, Irish spreads (chart above) dropped to 120 bps; but now the yield curve is even steeper, 170 bps as of 6am this morning.

The 3-yr Irish spread over German bunds is certainly coming under pressure, 492 bps (as of 6am today). But the front-end sell-off is nothing compared to that in Greece: spanning the period April 1 to May 1, 2010 (i.e. excluding the surge to 1700 bps), the 3-yr Greek spread over German bunds averaged 711 bps.

Further, the Irish debt profile is longer, on average, than that in Greece. The weighted average maturity on existing Irish debt is 6.1 years (starting in 2011), where that in Greece is a shorter 4.5 years.

The chart above illustrates the share of Irish and Greek debt by maturity date. 36% of Ireland’s sovereign debt expires through 2015, just half the share of Greek sovereign debt maturing by the same year, 70%. Note, too, that according to Bloomberg, Greece has 3 times the debt outstanding of Ireland – a completely different game (for now).

Irish bonds are certainly under pressure. But Ireland being funded until the middle of next year is important, making the timing of its return to market critical.

In my view, though, the quintissential issue is the government’s ability to finance its debt via domestic growth. Here’s a great paragraph from an op-ed in the Irish Independent last week:

While interest rates charged to Ireland have been rising sharply, many large countries can borrow at very low rates, as little as three per cent. Many economists have been arguing recently that these countries should consider a further fiscal stimulus package. Instead most of them are committed to deficit reduction. This debate is one that we cannot join, unfortunately. These countries have a choice since it appears that they could borrow more if they chose to do so.

We cannot do that, nor can we devalue our exchange rate, since we do not have one. It is perfectly reasonable to ask how we got into this mess, to allocate blame and to demand retribution. But no amount of ranting can expand the limited range of choices available to the Government.

Ireland needs revenues to finance their debt. We’ll see if the persistent fiscal austerity leads to growth – I’m totally skeptical.

Rebecca Wilder

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US Federal deficits

Mark Thoma posted yesterday Is Galbraith Right that Deficits are Never a Problem? on Paul Krugman’s NYT piece I Would Do Anything For Stimulus, But I Won’t Do That (Wonkish) on MMT and soveriegn debt (using Angry Bear’s posting of Jamie Galbraith’s testimony to Congress as a link), and has included Jamie Galbraith’s response. It is worth reading.

Ed Harrison at Creditwritedowns weighed in here.

Calculated Risk has posted a 5 series on Sovereign Debt both historical and comparative internationally.

More to come from other economists.

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