Products & Services About PIMCO Press Center Investment Resources Career Information Content Archive PIMCO Foundation
Viewpoints
This article was originally published on forbes.com on June 25, 2010.
Click here to read Andrew Balls' biography.
When the Federal Reserve started buying government bonds and mortgage securities last year via its quantitative easing program, it would have been hard to imagine the New York Federal Reserve rubbishing the idea "“ or the market reaction if it had done so. Yet in Europe, after the European Central Bank (ECB) voted one Sunday night in May to start buying up European government bonds, the Bundesbank "“ the eurozone's most important regional branch "“ made little secret of its disapproval. Since then the debate has rumbled on in public, with southern European representatives making the case for more aggressive action, if needed, in contrast to the Bundesbank's warnings. If the European sovereign crisis deepens, there is a chance the ECB might step in and use its balance sheet in a more aggressive and permanent fashion to absorb the problems of weaker member countries. But it might not.
This uncertainty illustrates an important secular investment theme. As we look out over the next few years, we face a secular outlook of a flatter distribution of possible outcomes and fatter tails, which is an investment professional's way of saying that there is a very wide range of possible outcomes rather than a single, dominant baseline scenario. This is true at the global level as the world economy recovers following the huge shocks of the past few years. And nowhere is this more clearly illustrated than in the eurozone, where the single currency area faces acute economic, institutional, coordination and political challenges.
The eurozone's governments and central banks made a slow start in responding to the eurozone sovereign crisis, and they continue to see the market as irrationally despondent rather than reacting to very real challenges facing a number of European sovereigns, the European banking system and the eurozone system as a whole. The policy response to date has been aimed at liquidity provision and the flow of government debt maturities and issuance and not at the stock of debt and solvency issues.
At root, the focus of the European stabilization fund and the ECB is to provide liquidity. Depending on how long the support lasts, the aim is to buy time for countries to make their fiscal adjustments and to try and grow their way into better debt dynamics.
The ECB so far has, rather halfheartedly, bought government debt at an average rate of about $8.5 billion euros per month, weighted very heavily toward Greece. That could change. That the ECB is buying any government debt is already a very significant about-turn given its prior pronouncements.
However, similar to the U.S.'s quantitative easing program, there are very big coordination and political problems to overcome and these are not just confined to central banking philosophy. It is not clear that the German public signed up for a monetary union in which the central bank might end up monetizing the government debt any more than they signed up for a fiscal transfer union. The logic of the â?¬500 billion European stabilization fund is that as and when weaker eurozone countries have to access the special purpose vehicle (SPV), the stronger countries "“ and ultimately Germany "“ shoulder more of the burden. That might happen. But then again, it might not.
Politics and the public attitude are not just important in the core countries, they are vital in terms of the fiscal contraction. A number of weaker European sovereigns are embarking on hugely ambitious fiscal tightening plans. They are doing this without the benefit of independent monetary policy and currency depreciation. Moreover, they are all attempting to tighten fiscal policy at the same time "“ including now Germany and France "“ with implications for overall eurozone growth. And countries without the option of exchange rate depreciation are simultaneously attempting to restore competitiveness via driving down real wages.
Clearly, fiscal austerity is not just a matter of announcing plans and setting targets "“ difficult as that can be "“ but of delivering over multiple years, including coping with the implications of fiscal contraction on economic growth, revenue and spending. There are a range of possible outcomes for the eurozone. At one extreme is successful fiscal adjustment, the creation of a deeper fiscal union and the creation of a European Monetary Fund "“ built on the foundations of the SPV "“ to ensure that this never happens again. At the other extreme it could involve exit from the eurozone by one or more countries, and it may not be just the eurozone's weakest members that will have to leave. It is possible that Germany may one day see the benefits of a return to the deutschemark outweighing that of European solidarity. The unthinkable has become thinkable.
In the middle, it could involve the preservation of the existing eurozone, albeit as a weaker entity and without government interventions being able to prevent one or more countries defaulting on their debt owing to overwhelming economic and political realities. Even with the full engagement of the ECB's balance sheet, the challenges of achieving growth and keeping investors engaged would remain.
The range of outcomes is wide, but it is skewed toward wider spreads and it is certainly very hard to see European sovereign spreads returning to their old normal levels other than in the most optimistic scenarios of successful outcomes on fiscal policy, overall coordination and political support. Greece's recent downgrade to non"“investment grade status emphasizes the extent of the challenge, with Greece now dropping out of the indexes of passive investors. The demand curve has shifted inward and given the extent to which other European sovereigns have traded relatively more as credit and less as interest rate risk, the impact may be more widely felt and prolonged.
There is a strong case for watching from the sidelines, to wait and see how policy interventions develop and the extent to which countries are able to deliver on their fiscal contraction without undermining growth. After all, for active investors, unless tied to the eurozone region for some reason, there is a world of global opportunities to consider, looking for higher-quality securities that are likely to achieve similar or better risk-adjusted returns to European government bonds.
Past performance is not a guarantee or reliable indicator of future results. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk. Sovereign securities are generally backed by the issuing government, obligations of U.S. Government agencies and authorities are supported by varying degrees but are generally not backed by the full faith of the U.S. Government; portfolios that invest in such securities are not guaranteed and will fluctuate in value. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Credit default swap (CDS) is an over-the-counter (OTC) agreement between two parties to transfer the credit exposure of fixed income securities; CDS is the most widely used credit derivative instrument.
This material contains the current opinions of the author and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Statements concerning financial market trends are based on current market conditions, which will fluctuate. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. This material was reprinted with permission of Forbes. Date of original publication June 25, 2010.
Read Full Article »