Sent: 21-12-2012 18:27:03
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Markets Lead the Way in Economic AdjustmentJohn Robertson
Safe haven government bonds with a guaranteed loss might sound a contradiction in terms but are one the latest tool in the kit bag of very nervous European investors as 2012 draws to an end. The Europeans are coming to terms with their reality. The same may not yet be true in Australia.
Yields on German Federal securities have been displaying successively lower lows and declining cyclical peaks since the beginning of the 1980s. When the downtrend began, many economists were finding it hard to foresee how single digit yields would eventuate. They would be shocked at how far they have fallen.
In late November, the Deutsche Bundesbank reported that securities with a value of 27 billion euros had been issued with a 12 month maturity and a yield of minus 0.0085%. Last week, six month paper with a yield of minus 0.0168% was issued.
Investors are buying securities with a rock solid guarantee of a loss! Upon maturity, investors will have received less than they had invested and from no less an issuer than the German government.
In setting these prices, investors are effectively saying they would rather pay the German government to hold their assets than take advantage of any of the alternative investments open to them.
Looked at another way, investors are saying implicitly "we are so scared of losses elsewhere that we would rather have the certainty of a known loss in the coming year than worry about what is going to happen to the bond prices of other countries".
In the event that Europe's monetary union fragments, having funds in the hands of German officials might be preferable to the alternatives. The German government is likely to return investments in the strongest remaining currency - that is, whichever the Germans decide to use in the future. One could not be as sure of that anywhere else.
Behind this extraordinary downward pressure on German yields is a banking system battling to survive by cutting its risk profile and, in the process of recapitalising, paying little heed to its broader impact.
Negative yields are probably as unsustainable as double digit yields were 35 years ago. Their continuation would erode savings, compromise the profitability of financial institutions and pull the rug from under the planning of pension funds. Fund managers and financial advisers would be seeking to maintain their income by taking an ever growing proportion of their clients' savings. Persistence of negative yields would herald financial chaos.
On a more positive note, the ability to differentially price government securities based on different national risk profiles is one of the few flexibilities evident within a system hamstrung by a common currency and all investors should be grateful that, at least in the immediate future, it is available to help ease the adjustment that is underway.
Having a choice between German and Greek securities, for example, offers a glimmer of hope that markets can adjust. And they are adjusting. Greek 10 year yields sitting around 13% might be saying there is a long way to go but, having come from over 30% 10 months ago, markets are saying the world is potentially in a safer place.
So, as the year finishes, Europe is adjusting and, perhaps, we could have hoped for nothing more. After all, Europe is always adjusting. Today's adjustment has its antecedents in the reparation payments imposed on Germany after the first world war. And those reparations were almost certainly motivated by an earlier history of warfare and mistrust. There is no reason to believe that in another 10 or 20 years Europeans won't be continuing to react to their history.
The bigger worry for Australians as the year closes is that the miracle economy is not the juggernaut some had thought.
Australia's lack of miracle economy credentials has been a periodic refrain in these weekly ATC emails. My article on 27 July 2010, for instance, began by cautioning that the Australian government was taking a big punt on the future of coal and iron ore prices and consequently "adding risks to the Australian economy that have not existed before".
At the time, equity market values were at odds with the view being taken by the government about future price trajectories. I asserted, with some safety, that one of these views was likely to be wrong. We should be bracing ourselves, I said, for a seriously large revaluation of Australian resource equities (if the government was right) or destruction of the underpinnings of the national budget (if the market was right).
The article went on to raise the possibility of government revenues being light on by some $6.8 billion a year by 2013/14 with a more realistic set of assumptions about commodity prices.
My reference to "the government" is not necessarily a swipe at Julia Gillard or Wayne Swan. The officials surrounding them have, quite simply, done them a disservice. The determined failure of officials in Treasury and the Reserve Bank to understand adequately the cyclical nature of the commodity markets in which Australia is engaged reinforced political instincts evident on both sides of politics.
So, as 2012 concludes, both Australia and Europe are searching for new economic paradigms. Both have been hamstrung by a limited range of policy options and both have been badly serviced by their policymaking bureaucrats.
Europe is in the better place now, perhaps in one respect. For the past three or four years its policymakers have been learning more about their problems and potential solutions. Meanwhile, Australia's policymakers are only just tumbling to the idea that, all along, they had been making policy in a fool's paradise.
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