Friday, March 23, 2012

Is the global "safe assets" bubble bursting?

The 10-year German bund and US T-Bond are ruling at historic low yields. As the graphics below indicates, the yield on German bund is slightly below 2% while that on US Treasuries is slightly above 2%.




Obviously, especially with the US, fundamentals cannot explain the historic lows. The US economy is just emerging out of a deep recession and there are serious question marks about the sustainability of this recovery. The German economy, while strong in comparison to its crisis-ridden Eurozone partners, faces serious external threats.

The widely accepted explanation for this historic-low sovereign bond yields is their role as perceived "safe-havens". Since the sub-prime mortgage bubble burst, the US Treasuries have emerged as the preferred safe and liquid asset for investors world-wide. America's burgeoning public debt and anemic economy has not prevented capital flight from emerging economies and elsewhere into US Treasuries, driving down their yields. Similarly, across Europe, once the real depth of problems faced by the peripheral economies became apparent in early 2011, the German bunds have emerged as the preferred safe haven.

In the US, apart from this, the Fed, through its quantitative easing and "Operation Twist" programs, played an active role in driving down longer-term sovereign debt yields in order to stimulate the economy.

Consequently, both assets have been driven to ultra-low rates. While this has helped both countries, especially the US, access foreign capital at cheap rates, and thereby reduce the impact of their real debt burden, it has had all the effects of an asset bubble in both countries.

Banks in US and Europe have stacked up massive quantities of German bund and US T-Bond. In fact, at these ultra-low rates, banks were effectively paying money to both central banks in return for the safety and liquidity these assets provided. Investors and hedge funds spent huge funds to buy into both securities to take advantage of its rising values. It appeared to offer them both risk assurance and handsome returns. An asset bubble in both these securities has been the inevitable result.

This trend has mirrored a similar rise in yields across their partners, especially among the Eurozone economies. The spreads with German bund of the peripheral Eurozone economies have risen sharply. Bond yields have risen in many emerging economies too as the global economic uncertainty increased.

That this is a full-blown bubble is borne out by the fact that sovereign bond yields on both securities are at their lowest for more than 40 years and nearly 25 years for US T-Bond and German bund respectively. Therefore, it is inevitable that these yields have to rise considerably before global bond markets regain their balance. The recent fall in the prices of both bonds, while very small, may be the trigger for the bursting of the US-German sovereign bond bubble.

With the world economy on the recovery path and Eurozone troubles appearing to have crossed its worst, the global bond markets are looking up. This would reduce the premiums associated with safe-havens and thereby set the stage for returning the German and US sovereign bond yields to their normal valuations. Though this will create its own set of problems, especially for banks which have stocked up with these safe assets, it bodes well for the long-term global macroeconomic balance.

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