We need to talk about Bunds

A shortage of safe assets in the eurozone is creating market distortions

Kate Allen


© FT montage; Bloomberg; Dreamstime


We need to talk about Bunds and the risk they pose to eurozone markets. No, I’m not joking.

Germany’s insistence on running a balanced budget and a current account surplus leaves no room for an expansion of its government debt — thus limiting the supply of German bonds, or Bunds, which are the eurozone’s safe asset.

The shortage exacerbates the price effect of European Central Bank bond-buying, widening the spread between German yields and those of riskier assets, such as Italy’s bonds.

The 10-year Bund yield reached the giddy heights of 0.8 per cent last year as investors’ minds turned to the end of quantitative easing and the timing of a rate rise. But it has since slipped to 0.1 per cent, pushing the spread against equivalent Italian bond yields to about 2.9 per cent.

The wider spreads are between ostensibly equal member states. The more volatile they are, and the more investors focus on them as a barometer of political risk, the more political the sovereign debt markets become.

EU budget rules aim to ward off excessive surpluses as much as deficits. They should mitigate against parsimony just as much as they are used against countries such as Italy for profligacy.

It is all very well to castigate Italy for its big debt burden, but not enough attention is paid to what happens when countries are not selling enough debt.

The euro was created “as a means of strengthening the political bonds between [European nations]”, according to the European Commission. Deliberately under-borrowing on your fiscal capacity, leaving the continent’s banks and pension funds with a shortage of safe assets, hardly helps fulfil that ambition.

Germany has in recent years run record budget surpluses and the world’s largest trade surplus, which last year led French president Emmanuel Macron to accuse his neighbour of “fetishising” surpluses.

The shortage of Bunds is arguably one of the drivers of exuberance in areas such as real estate. Investors need to put their money somewhere and there is not enough of what they actually want to buy so they are forced into substitutes which then rapidly become overloaded and suffer price bubbles.

It is rare to hear an argument in favour of increasing a country’s indebtedness, but the evolution of the bloc’s capital markets should also be on Germany’s agenda.

A way around Germany’s budget policies would be to create pan-eurozone debt instruments backed by multiple countries, but Germany is unwilling to tolerate mutualisation of debt. The eurozone already faces democratic challenges in pursuing further integration, so it is hard to blame it for that.

But that constrains the development of Europe’s capital markets because of the safe assets shortage.

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Investors Sound Warning About Markets’ Complacency on Interest Rates

Financial markets have rallied since the Fed dropped a reference to future rate increases; ‘it seems frankly optimistic to expect nothing from the Fed in the next 12 months’

By Akane Otani 

 
Some investors are concerned that the assumption underpinning markets’ rally—that the Federal Reserve has stopped raising rates—could be wrong. The floor of the New York Stock Exchange. Photo: Michael Nagle/Bloomberg News


Stocks and bonds are rising on bets that the Federal Reserve has ended its nearly four-year campaign of interest-rate increases, worrying investors who believe the central bank could upend those expectations later this year.

Since the Fed’s January meeting, a number of investors and traders have concluded that the central bank hasn’t just paused its rate increases, but finished them altogether.

Some believe the Fed’s next move could be to cut the benchmark short-term rate, something it hasn’t done since December 2008, when the global financial crisis forced the central bank to slash rates to near zero.

The shift is unsettling some investors who believe that much of this year’s rebound across stocks and bonds has been fueled by bets that the Fed won’t raise rates again in the foreseeable future. Loretta Mester, president of the Federal Reserve Bank of Cleveland, said Tuesday that interest rates should rise slightly this year assuming the economy grows at the pace that she expects. Money managers will get another look at the Fed’s view on interest rates and the economy on Wednesday, when the central bank is scheduled to release minutes from its January meeting.

The S&P 500 and Dow Jones Industrial Average have extended gains since closing out their best January in decades, with both indexes up around 10% in 2019 and at their highs for the year. Meanwhile, the yield on the two-year Treasury note—which tends to move in tandem with rate expectations—has fallen for three consecutive months, its longest such streak since 2013, according to Dow Jones Market Data. Yields fall as bond prices rise.

“It seems frankly optimistic to expect nothing from the Fed in the next 12 months,” said Isabelle Mateos y Lago, managing director and chief multiasset strategist at BlackRock. “When you look at payroll data, this is not an economy that’s about to be in recession.”

Much of the disagreement over the Fed’s next rate move stems from its decision in January to remove explicit reference to future rate increases from its monetary-policy statement. Before the January meeting, the central bank had included that language in all of its statements since 2015.

The removal, coupled with Fed Chairman Jerome Powell’s comment that “the case for raising rates has weakened somewhat,” helped send the Dow industrials soaring 435 points, or 1.8%, on Jan. 30. Now, federal-funds futures—used by traders to place bets on the course of monetary policy—show the market pricing in a 0.9% chance of the Fed raising rates at least once by year-end, down from about 30% a month ago, according to CME Group. 




Gautam Khanna, a fixed-income portfolio manager at Insight Investment, said he has been increasing the share of rate-sensitive securities such as Treasurys and mortgage-backed securities in his portfolios since the end of last year. That is a response to slowing global growth and growing evidence that the Fed is done raising rates, he said.

There are “too many risks out there,” Mr. Khanna said. “The lion’s share of what the Fed is likely to do this cycle is already behind us.”
Yet a number of fixed-income analysts say the Fed doesn’t appear to have ruled out future rate increases. Instead, they say, the central bank merely indicated that it is on pause for now.
“The communication shift basically went from explicitly saying further rate hikes are warranted to them saying, ‘I don’t know.’ And just saying, ‘I don’t know,’ doesn’t mean there are no more rate hikes coming,” said Jon Hill, vice president and interest-rate strategist at BMO Capital Markets.
One reason some analysts remain skeptical the Fed is done with rate increases: The economy, they say, looks far stronger than it did the last time the Fed decided to lower interest rates.
The U.S. labor market has added jobs for 100 consecutive months, the longest such streak in history. While inflation pressures remained stubbornly muted for much of the past decade, giving the Fed few reasons to accelerate its pace of rate increases, the tight labor market appears to have finally started to translate into a pickup in wages. The Labor Department’s January jobs report showed wages rose at least 3% on a year-over-year basis for the sixth consecutive month, building on what has been the biggest uptick in pay since the end of the recession in 2009.

“Some of the market having a high conviction that the next move is a cut fails to recognize just how tight the labor market is and the fact that growth continues to persist above trend,” Mr. Hill said.

Some pockets of the economy are starting to show signs of weakness. Data point to a cool-down in the housing sector. The Conference Board’s widely watched measure of consumer confidence has fallen for three consecutive months, while a report Thursday showed retail sales fell in December at the fastest pace since 2009.

Then there are variables like the U.S. and China’s trade conflict that stand to exacerbate a slowdown in economic momentum around the world.

“China is probably going to get worse before it gets better, and the U.S. will feel that slowdown,” said Andrea Cicione, head of macro strategy at TS Lombard, who believes the Fed is likely to lower rates by the end of the year.

Still, data on the whole point to an economy that is cooling—not sharply deteriorating. That leaves market bets, particularly for stocks and shorter-duration Treasurys, vulnerable to a reversal, analysts say.

“You don’t necessarily want to assume anything in either direction,” Mr. Hill said.


—Sam Goldfarb contributed to this article.

The Looming Taiwan Crisis

For many years, US policymakers worried that Taiwan would upset the apple cart: not content with the mere trappings of independence, it would opt for the real thing – an unacceptable outcome for the mainland. Now, however, the balancing act is threatened by both China and the US.

Richard N. Haass 




NEW YORK – Much of lasting significance happened in 1979. There was the Soviet invasion of Afghanistan and Iran’s Islamic Revolution, which brought to power a regime set on remaking not just Iranian society but also much of the Middle East.

Just as important was the United States’ decision to recognize, effective January 1 that year, the government of the People’s Republic of China – then, as today, run by the Communist Party – as China’s sole legal government. The change paved the way for expansion of trade and investment between the world’s largest economy and the world’s most populous country, and enabled closer collaboration against the Soviet Union.

Diplomacy was based on an intricate choreography. In three communiqués (in 1972, 1978, and 1982), the US acknowledged “the Chinese position that there is but one China and Taiwan is part of China.” It agreed to downgrade its ties with Taiwan and maintain only unofficial relations with the island.

America’s commitments to Taiwan were articulated in legislation (the Taiwan Relations Act) signed in 1979. The US stated that it would “consider any effort to determine the future of Taiwan by other than peaceful means of grave concern to the United States.”

The law stated that the US would support Taiwan’s self-defense and maintain the capacity to come to Taiwan’s aid. Left vague, however, was whether it actually would. Taiwan could not assume that it would; the mainland could not assume that it would not. Such ambiguity was meant to dissuade either side from unilateral acts that could trigger a crisis. Together, the three US-China communiqués and the Taiwan Relations Act form the basis of America’s “One-China policy.”

This structure made for a winning formula. The mainland has enjoyed the most successful economic run in history, becoming the world’s second-largest economy. Taiwan, too, has experienced phenomenal economic success and has become a thriving democracy. The US benefits from the region’s stability and closer economic ties to both the mainland and Taiwán.

The question is whether time is running out. For many years, US policymakers worried that Taiwan would upset the apple cart: not content with the mere trappings of independence, it would opt for the real thing – an unacceptable outcome for the mainland.

Taiwan’s leaders appear to understand that such a decision would be a grave mistake. But they reject the notion of Taiwan’s becoming a part of China under its “one country, two systems” rubric – a formula that has done little to protect Hong Kong’s special status – and refuse to endorse language (the “1992 Consensus”) used by Beijing to describe the relationship between the mainland and Taiwan.

Now, however, stability is also being jeopardized by both China and the US. China is experiencing a significant economic slowdown. This makes Chinese President Xi Jinping potentially vulnerable, as Chinese leaders have derived much of their legitimacy from economic success. The concern is that Xi will turn to foreign policy to distract public attention from faltering GDP growth.

Gaining control over Taiwan would accomplish this. Early this year, Xi publicly reiterated China’s call for unification and refused to rule out the use of force. What worries some in the region is that it cannot be assumed that a US administration that is leaving Syria, is signaling that it will leave Afghanistan, and is regularly critical of allies will come to Taiwan’s defense.

The US also seems less protective of the diplomatic arrangements that have worked for the past 40 years. Before becoming President Donald Trump’s national security adviser, John Bolton wrote in The Wall Street Journal that it was “high time to revisit the ‘one-China policy.’” Trump also became the first president (or president-elect, as he was at the time) since 1979 to speak directly with Taiwan’s president.

Most recently, five Republican senators wrote to Nancy Pelosi, the Speaker of the US House of Representatives, urging her to invite Taiwan President Tsai Ing-wen to address a joint session of the US Congress, an honor almost always reserved for heads of government or state. Doing so would be inconsistent with America’s unofficial relationship with Taiwan and would elicit a strong mainland response.

All of this is not taking place in a vacuum. It comes at a time when the US-China relationship has reached a 40-year nadir, the result of trade frictions and US unhappiness with Chinese assertiveness abroad and increased repression at home. A good many Americans, in and out of government, want to send the mainland a message and believe there is little to lose in doing so.

It is far from clear that this calculation is correct. A crisis over Taiwan in which the mainland introduced severe sanctions, imposed an embargo, or used military force could threaten the autonomy, safety, and economic wellbeing of the island and its 23 million people. For China, a crisis over Taiwan could wreck its relations with the US and many of its neighbors and rock an already shaky Chinese economy.

For the US, a crisis could require coming to Taiwan’s aid, which could lead to a new Cold War or even a conflict with the mainland. A decision, though, to leave Taiwan to its own devices would undermine US credibility and possibly prompt Japan to reconsider its non-nuclear status and alliance with the US.

In other words, the risks for all concerned are high. It would be best to avoid symbolic steps that would be unacceptable to the others. The status quo is admittedly imperfect, but it is far less imperfect than what would follow unilateral actions and attempts to resolve a situation that doesn’t lend itself to a neat solution.


Richard N. Haass, President of the Council on Foreign Relations, previously served as Director of Policy Planning for the US State Department (2001-2003), and was President George W. Bush's special envoy to Northern Ireland and Coordinator for the Future of Afghanistan. He is the author of A World in Disarray: American Foreign Policy and the Crisis of the Old Order.