Dysfunctional Bond Markets – A Comparison of Yields

Below we show the 10 year government bond yields of three countries: Spain, Japan and the United States. Also shown are budget deficits and total public debt as a percentage of GDP. It would actually make more sense to look at deficits as a percentage of tax revenues. The comparison of debt to GDP seems not to make a lot of sense intuitively, as governments cannot pay their debts out of 'GDP', but only out of tax revenues (note also that there are slight differences in the GDP calculations).

Anyway, the point is mainly to compare the three countries, as both Spain's and Japan's bond yields essentially reflect zero risk at this point. In fact, investors seem to assume that the combination of inflation risk and default risk in Spain and Japan is lower than in the US, which strikes us as slightly absurd, if only for “technical” reasons. An overview of annual CPI rates of change is shown as well.  Also included above the bond yield charts are the credit ratings assigned by the three big credit rating agencies (in this order: S&P, Moody's, Fitch).

Spain

Spain's credit ratings:

Spain's 10 year note yield has just plunged to a new low at 2.49%. This is quite an astonishing development – click to enlarge.

Spain – budget deficit as % of GDP – there has been improvement, due to a slight economic recovery and government spending being frozen (at a very high level) – click to enlarge.

Spain: public debt-to-GDP ratio – this ratio has grown by leaps and bounds since 2009 – click to enlarge.

Spain, CPI: consumer price inflation is reportedly very low in Spain at present, so if no bond default risk or euro break-up risk is assumed to exist, the current low yield on government bonds can be partly explained – click to enlarge.

Japan

Japan's credit ratings:

Japan: 10 year JGB yield. Currently this yield is almost 280 basis points below the most recently reported annual inflation rate of 3.4% (CPI) – click to enlarge.

Japan: budget deficit as % of GDP. There is no Japanese term for 'budget surplus', and if there is one, it has been forgotten - click to enlarge.

Japan: public debt-to-GDP ratio. This is a rather awesome statistic. As we have previously discussed, Japan's public debt has long acquired all the hallmarks of a giant Ponzi scheme - click to enlarge.

The 'success' of goosing inflation in Japan. Lately it looks like Mr. Kuroda has been almost a bit too successful, but money supply growth actually remains fairly tame thus far.  However, one must keep in mind that enough cumulative money supply growth has occurred  in the past to allow prices to permanently increase on account of contingent triggers such as the yen's recent decline in the forex markets – click to enlarge.

United States

US credit ratings:

US, 10 yr. Note yield – at roughly 2.6% it is the highest yielding bond market of the three at the moment – click to enlarge.

US: budget deficit as % of GDP.  The US deficit always declines to a relatively low level at the height of bubble periods, such as in the late 1990s, 2007 and now. It tends to expand rapidly once the bubbles burst - click to enlarge.

US:  public debt-to-GDP ratio. This ratio has risen to new record highs after the bursting of the real estate bubble. The trend is actually quite similar to that observable in Spain, the main difference is that the US government can print as much of its own money as it likes (the term 'money' is used loosely in this context. Government scrip is in a sense a pseudo-money. While it does serve as a medium of exchange, due to the secondary market demand that stems from its acceptance for tax payments and due to legal tender laws, such a money would never arise in a free market) – click to enlarge.

US CPI – recently the annual rate has increased to 2%. While this isn't much, it is ten times Spain's most recent annualized CPI rate – click to enlarge.

No Risk? Really?

Looking at government bond yields, we can see that investors are neither pricing in any 'inflation risks' (in the sense of a broad-based decline in money's purchasing power), nor seem they worried about potential default risks.

However, this is actually an inherently contradictory stance. It is clear, or at least it should be clear, that these debts will never be repaid – at least not on the same terms that obtained when they were contracted. There really are only two choices in the long run: 'inflating the debt away', which is a default by another name, or outright default (selective defaults are also a possibility).

Of the three countries discussed above, Japan is surprisingly actually about to come closest to option number one, as the BoJ is buying up staggering amounts of JGBs every month. Arguably, the US is also on its way to make this option a fait accompli, as the US true money supply has seen a vast expansion (+245% since 2000) and the Federal Reserve is by now stuffed to the gills with treasury bonds as well.

To this it must be remembered that such policies can be pursued for a long time without disturbing the markets much, so long as most actors in the economy can be convinced that the inflationary policy of debt monetization is only a temporary measure that is eventually going to be reversed. The risk is obviously that this isn't going to happen. Once market participants become worried that this risk may be greater than they have hitherto believed, things can go pear-shaped extremely fast.

In Spain's case, the risk of an eventual outright default is somewhat higher, as the ECB – in spite of Mario Draghi's ever longer list of announcements – remains restrained by its statutes regarding the buying of government bonds (monetary financing of government debt is explicitly ruled out by the ECB's statutes, but obviously, these statutes are a 'living document', a bit like the US constitution actually).

In Europe this constraint has been circumvented as follows: the ECB first made it possible for banks to discount all sorts of toxic dreck with it by lowering its collateral eligibility criteria to the point where there might as well not be any criteria at all. This allowed the banks to tank liquidity and to load up on the government bonds of essentially insolvent governments in turn. This proved to be – so far, anyway – a highly lucrative carry trade. It is a bit like Enron propping up Worldcom, only on a larger scale and back-stopped by the central bank, which can produce money from thin air in theoretically unlimited amounts.

The hope is obviously that governments will get their fiscal act together and that the economy won't fall apart again before they do. If this plan works out, it is expected that we can all return to 'business as usual'. The problem with this line of thinking is that the last boom has been so destructive and has consumed so much scarce capital, that economic recovery remains somewhat elusive. Consequently, any renewed downturn will be extremely painful and likely reignite the panic that has been officially declared over.

What is very worrisome in this context is that central banks have fought the post-boom recession all over the world by printing wagon-loads of money and pushing interest rates to zero – the same policies they have implemented before, only on a much greater scale. For unfathomable reasons, a great many people appear to expect a different outcome this time. However, bubble conditions have once again developed, which will undoubtedly prove unsustainable. What will be the encore when that becomes evident?

Note that we are not making a prediction regarding the timing of this event. There has been such a huge inflationary push that the effects continue to percolate through the economy and there is no way of objectively timing the inevitable turning point. It should also be clear that even during major inflationary bubble periods, there is always a certain amount of genuine wealth creation taking place, so the impoverishment from capital consumption that will eventually be unmasked is only relative to the situation that would have obtained absent the futile attempt to inflate us back to prosperity.

Anyway, central banks have engaged in a major experiment, piling one ad hoc policy decision upon another (surely no-one believes that the central planners actually have a plan – they don't. In fact, they have not the foggiest idea what will happen). Governments and corporations have vastly increased their debts during this most recent outbreak of central bank largesse, with outstanding debt securities increasing by $30 trillion to $100 trillion globally since the onset of the crisis (mind that this figure excludes the increase in bank credit). As we pointed out in March in an article entitled “The Big Debt Binge”:

“[...] in the six years to 2007, global debt doubled from $35 trillion to $70 trillion. This debt expansion seemed to stop in its tracks when the bubble imploded in 2008. In the six years since then, another $30 trillion in debt has been added.”

Apart from the astonishing extent of this debt bubble, it must be kept in mind that the most recent expansion spurt consisted mainly of additions to government debt – these funds have been consumed, but the debt remains on the books.

Conclusion

If bond investors really believe that there is no risk, they are kidding themselves. They are willing participants in what is ultimately a giant Ponzi scheme. As Ludwig von Mises pointed out:

“The long-term public and semi-public credit is a foreign and disturbing element in the structure of a market society. Its establishment was a futile attempt to go beyond the limits of human action and to create an orbit of security and eternity removed from the transitoriness and instability of earthly affairs. What an arrogant presumption to borrow and to lend money for ever and ever, to make contracts for eternity, to stipulate for all times to come!”

[…]

“It is obvious that sooner or later all these debts will be liquidated in some way or other, but certainly not by payment of interest and principal according to the terms of the contract. A host of sophisticated writers are already busy elaborating the moral palliation for the day of final settlement.”

A bonus chart: the most recent update of euro-system TARGET-2 balances. The improvement in these balances (which is a result of euro-area current account imbalances shrinking) has presumably contributed to confidence in European government bond markets. Note however that the imbalances are far from erased – click to enlarge.

Charts by: bigcharts, tradingeconomics, IFO Institute