By Richard Milne
Published: December 3 2010 20:25
Bond “vigilantes” might just have turned into something scarier. In a week when markets gave an unequivocal thumbs down to Europe’s attempt to contain its debt crisis through a bail-out of Ireland, the investment strategist who coined the vigilante description in the 1980s came up with a new metaphor for the investors who haunt debt-laden countries.
“The governments have created their own Frankenstein’s monster,” says the New York-based Ed Yardeni. “If you run a big deficit, then you create your own monster in the form of the bond markets.”
Like the runaway creature of Mary Shelley’s classic story, bond markets are on a seemingly relentless hunt for their next victim. With Greece and Ireland firmly in their clutches, their sights are now honed on Portugal, Spain and even Italy. It took aggressive emergency purchases of government bonds by the European Central Bank to restore some stability by the end of Friday.
Europe’s debt crisis entered a dangerous new phase this week and one that could prove decisive. No longer is the focus on small countries. The premiums that Spain and Italy, two of Europe’s largest economies, have to pay over Germany to borrow rose to record highs for the euro era on Tuesday. The very future of the single currency could be at stake should the full force of the crisis spread to them. That raises the pressure on European authorities to find a solution to satisfy the very bond markets that many of them like to blame for the turmoil.
Christine Lagarde, France’s finance minister, became only the latest politician to decry the “irrational” markets as she bemoaned investors pricing Spanish debt the same as that of Romania or Pakistan. “Europe is difficult to understand for the markets,” she told RTL radio, somewhat plaintively. But to outside experts and investors, that criticism misses both the point and the way markets function.
“It is preposterous for European politicians to claim that the whole crisis is being caused by irrational markets. The debt levels across much of Europe, both public and private, are off the charts,” says Kenneth Rogoff of Harvard University, a former chief economist at the International Monetary Fund.
Those debt levels create a huge dependence on the bond markets. Italy, which with outstanding government debt of €1,800bn ($2,400bn) is Europe’s biggest bond borrower, is expected to issue about €340bn bonds next year. Spain will have to raise €160bn-€180bn, according to analysts. Companies and banks in both countries also need to refinance hundreds of billions of euros coming due.
Retaining the confidence of markets is therefore crucial. Europe’s missteps in this regard appear to be legion. “No bail-out” one day, then “bail-out”; “no pain for creditors”, swiftly followed by “burden-sharing for investors”. The cacophony of messages coming from European leaders in recent months has confused – and scared – investors.
For many market participants, that meant the biggest announcement last weekend was not about the €85bn Irish bail-out but the European Stability Mechanism. Pushed by Germany, the ESM will be a permanent rescue vehicle for stricken eurozone countries. But the big difference to the current temporary arrangement used for Greece and Ireland is that investors will share in the pain of any debt restructuring after 2013.
That is seen by many as eminently sensible. “Only German chancellor Angela Merkel has really been forthright about the need for private lenders to bear some of the burden of the risks they took. Otherwise, Europe’s debt burden is just too much for the taxpayer to handle,” says Prof Rogoff.
But the timing of the proposal struck some as unfortunate, coming as it did while the crisis was still unfolding. The prospect of potential losses in the future spooked investors, sending 10-year bond yields for Spain and Italy up by more than a quarter of a percentage point on Monday and Tuesday. Yields had already spiked across the board since the proposal was first unveiled in mid-October.
Mr Yardeni explains: “The bond investors don’t want to take a hit and if the politicians make them take a hit they will close the markets down. The word is credibility: if you lose it, you lose credit too.”
The worries about losses underscore something fundamental about the bond markets. Unlike shareholders, whose upside is theoretically almost unlimited, the best bondholders can hope for is to get their money back, “to be made whole” in the parlance, as well as to receive regular interest payments. That means bond investors fight hard to avoid their risk on the downside: a default or restructuring, which would wipe out at least part of their investment. “It is an asymmetric return profile for us,” says David Leduc at Standish, the US fund manager owned by BNY Mellon.
In the past year the probability of default – as measured by credit default swaps, a form of investor protection – has soared in the so-called periphery of the 16-country single currency area, bringing investor fright. “The price action in the bond markets is being driven by real fears,” Mr Leduc says. Selling of Spanish or Portuguese bonds is designed above all, he adds, to avoid future losses: “There is no other intention than to protect the interests of our clients.”
Individually, investors are scared by the state of affairs in Europe, taking logical decisions to reduce their exposure to assets that appear to have become more risky. But collectively, that behaviour looks different: if most decide to sell, the result is a stampede. “Individually, it is driven more by fear than a vigilante desire to punish governments. But as a group investors are in effect maintaining law and order, because they have given up on expecting fiscal and budgetary discipline,” says Mr Yardeni.
The bond markets themselves are not homogenous. Robert Parker, a senior adviser to Credit Suisse, says they are three main types of investor who fall into the “scared” camp: pension funds, insurance companies and exchange traded funds. All three use bonds to match their liabilities but are inclined to sell when national credit ratings are cut. Some countries, such as Italy, have a strong retail market for individual investors too.
But the final type of investor falls more into the classic vigilante group: active asset managers or hedge funds. The include Pimco, which manages $1,200bn in assets – more than the annual gross domestic product of Portugal, Ireland and Greece combined.
Mr Yardeni came up with the “bond vigilante” phrase in 1983 when investors pushed up yields in spite of a weak economy because of the threat of inflation. The vigilantes hit Bill Clinton hard when he was president, provoking the administration to cut the deficit. It led his adviser James Carville famously to remark: “I would like to come back as the bond market. You can intimidate everyone.”
Describing himself as “an anthropologist following this tribe”, Mr Yardeni sounds like he longs for the days of yore when talking about its members. “I have been a bit disappointed with them in the last few years. They have been very low-key and living in a sheltered neighbourhood called the yield curve,” he says, referring to the higher income that investors usually receive for holding longer-term debt.
In particular, he believes they failed to be vigilant in the years building up to the financial crisis, as they let debt levels explode but still allowed countries such as Greece and Ireland to borrow cheaply in the markets. “They fell asleep at the switch. But now they have the cheek to tell Angela Merkel and other leaders: ‘we weren’t very vigilant but we expect to be made whole on our investments’,” he says.
The question now that they have woken up again is: what will end the crisis? Markets had pinned their hopes on the ECB announcing a big increase in its purchases of bonds. The Frankfurt-based central bank failed to do so explicitly but it quietly intervened in the market, pushing Portuguese and Irish 10-year yields down by more than a percentage point, their most dramatic drop since May.
But the ECB is treading a delicate path. It is trying to guard its independence and insists governments must take much of the action. At the same time, Jean-Claude Trichet, its president, has underlined his determination to face down critics of the euro project. Until this week, the ECB had bought €67bn of peripheral government bonds but some in the market think it needs to aim for €1,000bn-€2,000bn. That is unlikely but the increase in its purchases on Thursday and Friday suggests it will intervene if necessary.
Some investors have gone further and called for fiscal union, something the ECB desires but is resisted by Germany and others. Overall, European authorities still appear to believe they can buy the time to solve the issue through budgetary rigour in countries such as Portugal and Spain.
The problem is that bondholders no longer appear content to wait. “The market is less willing to accept half-measures. The volatility will persist until they see some sustainable policy,” says Mr Leduc.
The prospect of a more dramatic end is being floated, and not just by investors. Herman Van Rompuy, president of the European Council, which groups EU national governments, warned last month that the eurozone was “in a survival crisis”.
Mr Leduc agrees: “Most of the price action has been a referendum on how serious the countries are about preserving monetary union.” The time to convince those voters is running out.
Copyright The Financial Times Limited 2010.
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