This is the world we live in today: Stocks are priced as if the global economy is booming, while the bond market is priced as if we’re in a worldwide depression.
Nowhere is this truer than in Europe, where stocks are at or near record highs while yields on sovereign bonds are at record lows, below zero in many cases.
Of course, we’re neither in a boom or a bust. While we’re closer to the former in the U.S., we’re a lot closer to the latter in Europe. The bond market in Europe is telling us that the euro zone economy’s in the tank, which is much closer to reality, while the stock market there is now trading at a seven-year high.
And who do we have to thank for this bizarre – and ultimately unsustainable – situation? The world’s central banks, led by our own Federal Reserve, which basically started the whole concept of “quantitative easing” that has grossly distorted the value of financial assets.
Now that our Fed seems to be at least contemplating “normalizing” monetary policy – i.e., raising interest rates above zero – practically the rest of its foreign counterparts are only now starting to ramp up their own QE programs.
This month the European Central Bank begins the expansion of its asset-purchase program to include sovereign bonds. But before it even bought a euro’s worth of the bonds, the prospect of it doing so drove up both stock and bond prices to record levels.
Last week the yield on German five- and seven-year government bunds (that’s what they call them in Germany) dropped below zero for the first time. Essentially, investors are paying Berlin for the privilege of holding their money. However, that’s a higher “yield” than leaving it on deposit at the ECB, where the deposit rate is even lower, at negative 0.2%.
The yield on the benchmark 10-year bund isn’t far from falling below zero, too. Last week yields on those securities fell to 0.26%, putting them even lower than comparable Japanese bonds, which previously had the lowest bond yields among the world’s major economies, largely because the economy has been stagnant for much of the past 20 years.
And the odds are pretty good that German yields will continue to fall. The Wall Street Journal reported that German government securities are in short supply and getting smaller. When the ECB starts buying sovereign bonds, German bunds will account for more than a quarter of the total – owing to Germany’s status as the largest economy in the euro zone – or around €12 billion each month.
The problem is that net new German debt issuance is expected to total €15 billion – for the whole year! – as the government has been running a budget surplus and cut back on new debt issuance.
But German bunds aren’t the only securities that have benefited from the ECB’s prospective QE program. Irish 10-year debt fell below 1% for the first time, while comparable Portuguese bonds fell below 2%.
To put that into perspective, yields on comparable triple-A rated U.S. government bonds were yielding about the same as Portugal’s, which are rated below investment grade. Does that make any sense?
So how do we play this, or better yet, how do we protect ourselves when this house of cards inevitably collapses?
Greek stocks and government bonds soared in a relief rally after Athens won four month’s breathing room with its bailout extension, although the issue will have to be addressed again come June.
The question is, which is a wilder speculation: Buying German and other euro zone government bonds with zero interest rates or others that have been driven down artificially, or making a bet on Greece’s economic recovery and remaining in the euro zone? Where are you likely to make the most money – or perhaps better phrased, where are you likely to lose the least?
I’d say it’s a toss up.
In this insane investment world, it seems that the riskiest bonds – meaning those most likely to fall in price – are gilt-edged securities like German bunds, since they seem to have nowhere to go but down. By contrast, the bonds with the least risk would seem to be those with relatively little downside risk and lots of upside potential.
Let’s look at Greek sovereign bonds again. Last week Greek 10-year bonds were yielding about 9.5%, or about 800 basis points – eight full percentage points – more than comparable Italian and Spanish bonds.
Is there really any chance that the country’s lenders will allow it to default, and is there really much chance that its partners in the euro currency area – including Germany – will it allow it to? Probably some chance, but not a lot. While it might be a smart thing to let Greece leave, how sure could the rest of the European Union be that other members wouldn’t eventually leave, too? They could never take that chance.
This is Europe, remember. Our leaders in Washington are routinely and justifiably criticized for constantly putting off dealing with serious issues – Medicare and tax reform, anyone? But we have nothing on the Europeans, who practically invented that kick-the-can game.
Look at how quickly the euro zone finance ministers approved Greece’s four-month bailout extension after Athens submitted its request for the extension. Less than 24 hours. Do any of us think they could get a mortgage loan approved that quickly?
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INO.com Contributor - Fed & Interest Rates
Disclosure: This article is the opinion of the contributor themselves. The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. This contributor is not receiving compensation (other than from INO.com) for their opinion.