Is the Risk Free Premium Dead?
Peter is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
If there is one thing that the events of the past few months have taught us it is that any mathematical model based on the default risk premium of a government bond is not zero. While millions of MBA students the world over are being inculcated in this concept, the truth is that it is as close to reality as any current Greek budgetary prediction. We accept that there is a default risk premium to be paid on corporate bonds. By definition because of the existence of a non-zero default risk probability associated with a corporate bond they will have to offer higher yields to offset this amount.
So, why is it after all of this time are we still laboring under the delusion that default on a government bond cannot happen? The concept that governments do not default on their bonds is do deeply ingrained into our thinking about markets that we are still having a hard time properly going about the business of quantifying what the potential for default actually is.
The current situation in Europe is indicative of this. If one uses the credit default swap spread as a proxy for this we can quickly see that there is a default risk premium associated with government debt. German debt, for example as of this writing, is back over 100 basis points and within 16 of the high set last fall. Egan Jones just downgraded German debt again to A+ outlook negative. My home of Vietnam carries a non-investment grade rating from the big three agencies, but above junk status, while Spain’s debt has been downgraded to junk bond status.
At this point the U.S. Treasury market is trading like an unsustainable parabolic market. The PIMCO 1-3 Year U.S. Treasury Index Fund (NYSEMKT: TUZ) returns just 0.47% yield. The iShares IBoxx $ Invest Grade Corp Bond Fund (NYSEMKT: LQD) is paying a 4.1% yield. I grant that compared to Spanish debt the U.S. debt is essentially risk-free. But, in an absolute sense just because U.S. debt is better than Spanish debt doesn’t make U.S. debt any good. And yet the flows continue: $57 billion in U.S. Treasury securities in March and April alone (latest data), in a kind of prisoner’s dilemma scenario that continues to spiral upwards.
In the deflationary environment of Europe, the default risk premium on government debt is skyrocketing, CDS spreads are blowing higher by the day. Ratings agencies can’t downgrade banks (and countries) fast enough and still money flows preferentially into the bonds of the two strongest central banks on the planet, the Federal Reserve and the Bank of Japan, even though their banks have exposure to the debt in Europe that is exploding. This is because they have at their disposal, unlike the ECB and many others, the ability to guarantee that their bonds will be paid via the printing press or at least its electronic equivalent, even if it means destroying their currency in the process.
So, while the default risk premium on U.S. and Japanese debt is low, the reality is, of course, that the stock of debt can only be increased for so long before the threat of devaluation overwhelms the potential return. At this point these two markets are a self-feeding gyre of higher prices begetting higher prices as the capital gains turn into DV01 gains to satisfy capital adequacy ratios offsetting the deterioration of other assets on the banks’ balance sheets.
All of this is leaving aside the fiscal insanity that persists in both countries which needs to be financed through debt creation. At least for Japan someone outside of the death grip of the European fear trade wants to hold JGBs. China and much of the rest of ASEAN as well as the BRICS are accepting tens of billions in direct investment from Japan and Japanese companies and recycling them into JGBs, the percentage of which held by foreign investors just hit a 25 year high of 8.5%. For the U.S. the rate of accumulation of foreign held U.S. treasury debt, net, is slowing on a percentage basis.
The Fed is either playing a dangerous game of chicken with the market daring it to continue buying U.S. Treasuries to maintain control of the global monetary system or it has flown itself into what aviators call coffin corner forever having to fly higher and faster to keep from stalling. By refusing to alleviate the fear trade and get ahead of the European deflation situation, the Fed is setting the stage for the inevitable stall in U.S. Treasury purchases. And it will either have to openly monetize everything the Treasury needs or flush the U.S. banks down the river, while at the same time absorb the trillions in foreign holdings now looking for an exit at insanely high prices.
The CDS market is frozen between 48 and 50 basis points (in Euros) for U.S. 5 year debt. At the height of the Lehman failure it reached 100 basis points and that broke the system. The 3 month OI swap rate is at 0.18% rising steadily. Neither of these measures indicates any kind of real stress yet. But they bear watching.
If and/or when (depending on your perspective) they rise significantly Gold will shoot higher, and with it flows into the SPDR Gold Trust (NYSEMKT:GLD) will return with a vengeance. At that point the bull market in U.S. Treasuries will be over and with it all illusions of a risk-free anything as investors all attempt to get out at the same time.
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