The economic costs of severe financial stress are so high and so long lasting that developed-world policymakers will still be pursuing financial repression as a way to contain the consequences for years to come. That was the message from Morgan Stanley’s chief US economist Vincent Reinhart, in a compelling presentation this week at Euromoney’s annual bond congress. The final conclusion might look surprising to some bond market participants: go long five and 10-year Spanish government bonds. This is a counter-consensus call, in the aftermath of an Italian election result that has revived unease over peripheral eurozone government bonds now trading as credit assets.
Justin Knight, European strategist at UBS, was voicing the fears of many at the start of this week, when he noted: “Higher yields and/or higher volatility will likely stop many investors from taking long positions in peripheral markets at this stage, and have the potential to trigger selling by those who already are long.
"This shift may have a greater impact on Spain than on Italy. As we note regularly, the balance of supply and demand for Spanish bonds is fragile. Demand relies heavily on a limited number of foreign investors while the Spanish government's gross funding needs are running at around five times the pre-crisis levels. In addition, the macroeconomic backdrop is very challenging.”
Morgan Stanley’s buy call on Spanish debt does not reflect a rosier view of that country’s economy or finances; rather it is a bet on the ECB’s and EU’s response.
Reinhart, together with his wife professor Carmen Reinhart and Harvard University’s Kenneth Rogoff, wrote an influential paper for the IMF last year on the history of debt over-hangs: episodes when government debts breach 90% of GDP and worries rise about sustainability. They found that the average duration of 26 such episodes since the Napoleonic war was 23 years and that the long duration implies that cumulative shortfall in output from debt overhang is potentially massive.
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Reinhart reminded his audience at the Euromoney bond congress that a constant in such episodes was that in the 10 years after such a public debt crisis breaking out, per capita GDP was 15% below where it would have been if the trend of the prior 10-year period had continued.
He also reminded his audience that when most developed world governments cannot pay down their large stocks of existing debt, are struggling just to rein in annual budget deficits that continue to increase the debt and low growth also hurts their debt ratios, then the one variable they will bend every effort to controlling is the cost of servicing that debt. Policies that allow some inflation to dilute the net present value of the debt and that promote negative real interest rates are the classic plays central banks and finance ministries, working with aligned interests, will pursue.
Reinhart knows of which he speaks. He spent more than 20 years at the Federal Reserve, the last six of which he served as director of the division of monetary affairs and secretary and economist of the Federal Open Market Committee as the senior staff member advising Fed officials on monetary policy.
He says that the classic playbook remains “to tilt the playing field towards government securities, for example by imposing higher liquidity buffer and reserve requirements, by increasing the emphasis on ratings of government bonds in higher capital requirements and by slowing the velocity of collateral in the financial system so participants have to own more government securities”.
Glenn Hadden, global head of interest rates at Morgan Stanley, adds that part of the authorities’ playbook “is to try to pick winners among assets in a form of directed credit, as for example with housing in the US where the Fed has been buying mortgages”.
Hadden says the single biggest bet bond investors could put on to piggy-back on policymakers' efforts to control financial markets is buying inflation-linked Japanese government bonds, as the government and the central bank appear to have only just begun a new policy of pursuing negative real rates and higher inflation.
Technical bid for Spain
In Europe, policymakers nearly made a bad error in forcing an overt nominal loss on holders of Greek government bonds and have learned their lesson, says Hadden. Lowering real government bond yields and encouraging inflation is now the goal in imposing a covert tax on investors.
Carlos Egea, analyst at Morgan Stanley and previously on the staff at the ECB, draws the circle back to Spanish government bonds. He points out: “The ECB and European policymakers have chosen certain assets to target by lowering risk weights, lowering ECB haircuts on government bond collateral and using the LTRO to finance the carry trade.
"If you look back to the 1990s, maybe 15% to 20% of the assets of any Spanish or Italian bank were government bonds. That then fell. But now, financial repression makes it much more rewarding to own yielding government bonds. Last year, a Spanish bank could earn a 30% return on equity by buying five-year Spanish government bonds. That has since come down to 9% to 12% and you can see them stretching to 10-years. Meantime, the return on equity for a bank lending to an SME is close to zero.
“For Spanish, Italian and Portuguese banks, running big government bond portfolios is much more profitable than lending to the real economy.”
He suggests that policymakers’ subsidies for strategic assets and real-money investors’ need for yield against a backdrop of low real returns might see the spread of Spanish government bonds over Bunds decline from nearly 350 basis points to 225bp in the next 12 months.
It’s a bold call, partly because the tail risk is that policymakers’ efforts to contain the crisis might simply blow up in their faces. Reinhart admits: “Episodes of financial repression that end quickly tend to end badly.” He hopes it doesn’t come to that: “Governments aren’t going to roll back a hidden tax that makes the cost of servicing their debts lower, unless it is forced upon them.”
