If it looks like a bond, and it acts like a
bond…oh…that’s the problem. Government bonds aren’t acting the way investors
expect.
Last week, 10-year U.S. Treasuries – which,
typically, are thought to be safe and stable investments – suffered the biggest
one-week sell off since June 2013, according to The Wall Street Journal. Treasuries finished the week yielding 2.4
percent, a gain of 0.3 percent. In the world of stodgy,
backed-by-the-full-faith-and-credit-of-the-U.S.-government-bonds, that’s a big
change.
The performance of U.S. bonds paired with
that of German government bonds. BloombergBusiness
reported 10-year Bunds delivered their worst weekly performance since 1998. On
Friday, the German benchmark bond settled at 0.8 percent after rising to almost
1 percent on Thursday. In late April, the yield on Bunds was at an all-time low
of 0.049 percent.
So, what’s going on? Why are bond values
fluctuating so much? Barron’s said
the problem is a lack of liquidity in fixed-income markets:
“The global financial system is awash in
liquidity, created by central banks as they have driven short-term interest
rates to zero (or even below) and expanded their balance sheets by the
equivalent of trillions of dollars. And so the world is swimming in cheap
money. At the same time, liquidity is said to be at a low ebb in the financial
markets, especially for bonds… As a result, transactions that once didn’t cause
prices to budge now send them lurching from trade to trade… And the advice from
central bankers on both sides of the Atlantic about this new volatility? Get
used to it.”
One reason for the lack of liquidity is the
relative scarcity of market makers, reported Barron’s. In the past, banks made markets – buying and selling for their
own accounts – which created liquidity, but new regulations have curtailed those
activities.
Looking beyond bond market illiquidity, there
was economic good news in the United States: employment numbers improved. However,
investors worried that could push the Federal Reserve toward a rate increase
sooner rather than later, and U.S. stock markets finished flat to lower for the
week.
When a government has a lot
of debt, is it better to
implement an austerity plan and pay the debt down? Or, take advantage of low
interest rates and invest in the country?
Since the financial crisis, countries around the world have racked
up a lot of debt through stimulus programs, financial bailouts, and other monetary
and fiscal rescue efforts. When Should Public
Debt Be Reduced?, a new paper published by the International Monetary Fund
(IMF), reported advanced economies currently have some of the highest debt
ratios of the past 40 years.
So, should they be paying off their debts? It all depends on how
much ‘fiscal space’ your country has, according to the IMF. The Economist explained it like this:
“This concept [fiscal space] refers to the
distance between a government’s debt-to-Gross Domestic Product ratio and an
“upper limit”, calculated by Moody’s, a ratings agency, beyond which action
would have to be taken to avoid default. Based on this measure, countries can
be grouped into categories depending on how far their debt is from their upper
threshold… It is a decent measure of how vulnerable a government’s finances are
to a shock.”
The IMF report concluded countries already at the upper limit – like
Japan, Italy, Greece, and Cyprus – are out of luck. They must take action to
reduce debt levels. However, for countries that have fiscal space, there may be
merit to the idea of “simply living with (relatively) high debt and allowing
debt ratios to decline organically through output growth.”
In other words, if the country’s economy grows faster than its
debt, the debt will become a smaller percentage of GDP, resolving the debt
issue gradually over time. Given enough time and economic growth, the problem
could resolve itself.
The IMF cautioned these conclusions do not constitute policy
advice. The paper was intended to fuel debate about the proper course of action
for rich, but indebted, countries.
Weekly Focus – Think About It
“You have brains in your head. You have feet
in your shoes. You can steer yourself in any direction you choose. You're on
your own, and you know what you know. And you are the guy who'll decide where
to go.”
--Dr. Seuss,
American writer and cartoonist
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