Bond Markets, Greece, the Fed & the ECB

Bond Markets, Greece, The Fed & The ECB April 28, 2010, David Kotok, Chairman and Chief Investment Officer

The shock from Greek debt pricing and credit-rating agency downgrades of Greece and Portugal has caused a flight to quality among sovereign debt issues.   There is now a great divide between high-grade and junk.  Junk-status debt trades with double-digit yields.  Those markets have been rendered nonfunctional.  

High-grade sovereign debt like US treasuries, German bunds, and Japanese JGBs have rallied to low yields.   Other high-grade global credits have followed.  The spread between low-grade and high-grade sovereigns is measured in hundreds of basis points. It used to be in tens of basis points. 

This debt crisis, like every other in the history of modern finance, will eventually be resolved with a restructuring and change in the debt regime of the sovereign state that issued debt with profligacy. Greece will pay a hefty price for its failure to control its budget.  Other states are watching and learning. Ireland, Latvia, and Uruguay are examples of states that changed their behavior with success.  Argentina is an example of failure of government; it still cannot access the world’s capital markets.  In the US, New Jersey is an example of a state that is trying.  Illinois is still struggling.  Michigan’s policy hasn’t changed enough, but hopeful signs are emerging.  California need no longer hear that its credit rating is the same as Greece’s; Greece’s is now lower.

Meanwhile, all this has implications for US monetary policy, which is why there will be no change in the Fed Funds rate announced today and why the Fed is likely to continue its “extended period” language and keep short-term interest rates low for the rest of this year.

Debt crises injure the credit mechanisms.  They cause the credit multiplier to contract.  They instill fear and thus psychologically damage the market agents who deal in them.  All this comes at the same time the US financial reform bill is advancing and the Goldman-Paulson-Tourre affair has dominated the news of the world’s largest debt issuer and in the world’s largest debt market.  The US is getting a temporary respite, and that reflects in the rallying treasury yields.

One open issue is to be determined.  Will the Europeans sacrifice a half-century of work by undermining the euro?  That is where the global rubber now hits the road.  The euro had the makings of becoming the world’s second reserve currency.  It had reached a level of about 25% of world reserves.  The dollar was down to 65%.  All others and their gold hoards totaled only about 10%.  

If the European Central Bank (ECB) uses its printing press to bail out Greece, it will permanently open itself up to global distrust.  In order to avoid that, it must allow the risk of member banks’ holdings of Greek debt to evolve, and that means there may be losses.  Otherwise, the euro will be undermined by the very central bank that was created to avoid such an outcome.

The euro took a thousand years to create.  After a millennium of killing each other, the Germans and the French decided to set aside war and advance the notion of an economic union, open trade, and transparent borders.  Travel, commerce, and finance between Berlin and Paris has never been easier than today.  Undoing this good work is the risk the ECB will take if it undermines the strength of the euro by making a disastrous policy error. 

These decisions are now in the hands of the ECB governing council.  Unlike the US Federal Reserve, the central bank in the eurozone is protected by a treaty and may act independently of the pressures put on it from any single sovereign state.  Their single mission is to preserve the value of the euro and the steadiness and predictability of the monetary policy.  The world now watches. 

We exited our strong euro position months ago.  Whew!  We are only carefully selecting country exposure in our European ETF strategy. Our colleague Bill Witherell is drafting a piece about this now and it will be released soon.  

We have raised cash and are patiently waiting before we redeploy it into markets.   This is a fascinating and challenging time to be a money manager with stewardship over billions in separate accounts.  The goal is to preserve the capital of the clients as the events unfold and to deploy it in the areas where we can be most opportunistic. 

Cumberland AdvisorsSM is registered with the SEC under the Investment Advisors Act of 1940. All information contained herein is for informational purposes only and does not constitute a solicitation or offer to sell securities or investment advisory services. Such an offer can only be made in states and/or international jurisdictions where Cumberland Advisors is either registered or is a Notice Filer or where an exemption from such registration or filing is available. New accounts will not be accepted unless and until all local regulations have been satisfied. This presentation does not purport to be a complete description of our performance or investment services.

Please feel free to forward our commentaries (with proper attribution) to others who may be interested.

For a list of all equity recommendations for the past year, please contact Therese Pantalione at 856-692-6690,ext. 315. It is not our intention to state or imply in any manner that past results and profitability is an indication of future performance. All material presented is compiled from sources believed to be reliable. However, accuracy cannot be guaranteed.