When Will The Bond Vigilantes Attack The U.S. And U.K.?

by: Jeremy Robson

At present, the bond yields on US treasuries and UK gilts are falling, as they are benefiting from money flows out of the EU countries. Both countries are perceived as 'safe' and so the money flow is quite strong. 10 year yields in the US are below 2% and hovering around 2.2% in the UK. For all the people who have shorted both treasuries and gilts this must be very frustrating. The question is how long can this go on?

The present money flows into the US and UK bonds rely on:

1. How long the debt crisis in the Euro goes on.

2. The sustainability of the US and UK fiscal positions.

3. Sentiment towards the risk of US and UK bonds.

To find out when the flows may reverse we need to analyse the 3 points above.

How long will the Debt crisis in the EU go on?

At present the crisis in the Euro is escalating and the bond yields are rising in every Euroland country. This cannot continue indefinitely, so at some stage soon there will be a 'seminal moment' when the crisis either results in a financial meltdown or a solution (whether partial or total). For the purposes of this article I think that it is irrelevant which occurs. If a meltdown occurs, the yields on the US and UK bonds will likely go much lower than if a solution is found. However, in both cases the holders of the EU bonds will have taken their actions. In a meltdown they will have sold their bonds, in a solution they will be happy to keep their bonds. So in either case the bonds of the EU countries will have reached an equilibrium. The result in both cases is that money stops flowing out of EU bonds and into US treasuries and UK gilts. The only difference is the prevailing rate of the US and UK bonds at that time. It therefore seems to me, that at that time, one of the present props of US and UK yields is removed. No more 'safe haven flows'!

The crisis in the Euro is not easily fixed, so it would seem that the solution/meltdown will not come immediately. It is likely to go on for a period of between 3-6 months. During this period any attack on the US and UK bond markets is extremely unlikely.

The sustainability of the US and UK fiscal positions

United States

Government debt/GDP 103%

Total debt/GDP 363% (2010 figure)

Budget deficit as a % of GDP 8.9%

The US legislature is presently deadlocked and the consensus view is that it will stay that way until after the November 2012 presidential elections. It seems that in the next year there will be no fiscal consolidation/austerity. With growth presently around 1.7% annually and a budget deficit of 8-9%, the fiscal position is totally unsustainable. Behind the rhetoric, there is genuine concern about the fiscal position in the US (both from within the US and externally). The world is just waiting for the US to come up with a reasonable plan. Until they do, a bond market meltdown is a very real possibility.

United Kingdom

Government debt/GDP 63%

Total debt/GDP 464% (2010 figure)

Budget deficit as a % of GDP 10%

The UK has started fiscal consolidation and the budget deficit is projected to fall to under 8% of GDP in 2012. However, this is still very high. The question is; are the projections for budget deficit reduction achievable? The IMF estimates that growth in the UK for 2011 to be 1%. However, the OBR (Office for Budget Responsibility), who are now responsible for budget projections in the UK, stated in the summer that the structural budget deficit is £12bln bigger than their previously forecast. The government has not responded to this and has not changed policy. The OBR growth rate assumption in their deficit reduction targets for 2012 was 2.5%. It is now 1.7%. This still seems very optimistic and will not be hit. The deficit reduction to 8% will therefore also not be hit. In his recent Autumn statement the Chacellor suggested that borrowing will be 100bln higher than previously forecast. Further austerity in the UK will be needed. In all countries that have tried austerity the 'paradox of thrift' has then kicked in. I can see no reason why the UK should be any different, especially considering the dramatically high total debt/ GDP ratio. This is also a totally unsustainable position. Once again the ammunition needed for the vigilantes seems to be there.

So my conclusion is that at some time in the future, the bond markets will turn their attention to the US and the UK. This will result in higher bond yields and an increased debt servicing cost,at a time when both countries can least afford it. But when?

Sentiment towards the risk of US and UK bonds

As already discussed, if the Euro crisis lasts 6 months, yields on both countries' bonds will likely fall during this period. After that (if 6 months turns out to be correct) I feel that the timing of the bond price falls/ yield rise is different for the 2 countries. For bond prices to fall the markets have to lose confidence in the long term fiscal sustainability of the country.

In the US, the period until the middle of 2012 is likely taken by the EU crisis. I believe that markets will focus, in the second half of 2012, on the presidential elections with large doses of 'hopium' being enough to keep yields stable. However, once the president has been sworn in, the realization that nothing is going to change will set in. The president will truly have no clothes (metaphorically speaking). 'Hopium' will no longer be enough. Bond yields in the US will start to rise in the Spring of 2013. The US crisis will have begun.

In the UK the first half of 2012 will be OK for the same reason as for the US - The EU will keep the market's attention. However, during this period the fiscal problems of the UK will become more apparent, as growth falls way below target. By the Summer of 2012 further austerity measures will have been introduced. By the fall of 2012 the effect on growth will be evident. The position will be getting away from the policy makers. Yields will rise to reflect credit risk as the crisis unfolds in the UK.

I would like to add one last point. There is much comment from economists (particularly Cullen Roche on Seeking Alpha) that bond default in countries that have their own currencies is impossible. The credit risk is therefore minimal and so crises are unlikely to occur in these counties bond markets. They also suggest that the issuance of bonds in those countries is almost like an accounting entry to mop up liquidity in the system.

I would counter both points.

It seems to me that it is irrelevant to bond investors if they lose their capital by default or by inflation created by monetization of debt. In both cases they have lost their capital, just by different routes. Both are therefore reasons to sell bonds. So although it is technically impossible for a sovereign country to default on it's debt, it will not stop bond market crises from occurring, just because the country can print money to repay the debt. The bond market in this instance would fall because it perceived the risk of inflation. The result is still the same. The only point I do concede is that being able to print your own currency gives some comfort to investors; in effect it raises the bar for a bond market crisis. This is likely why the crisis has occurred first in Europe.

As regards to excess liquidity mop ups. Where excess liquidity goes is in the hands of the holders of that liquidity. In a global market it can go anywhere. It may well not go into sovereign bonds. To say that treasury auctions are a liquidity 'mop up' does not mean that investors will not shun auctions. They undoubtedly will.

Investment implications

I do not presently hold any sovereign bonds. If I did however, I would use the highs that the crisis in Europe produces to scale out of US and UK bonds, despite the fact that US bonds will likely not see their prices fall meaningfully until 2013. I will likely not short either bonds until the dates I have indicated above come into view.

This article is not intended as investment advice. Before taking any action, please do your own research. Do not rely on any opinions or facts included in this article for decision making.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.