By David Stockman, Budget Director under President Reagan and author of the bestseller, The Great Deformation: The Corruption of Capitalism in America. This article originally appeared on David Stockman’s Contra Corner.
About 36 months ago Ireland’s two-year notes were yielding 14% and its government and the Brussels apparatchiks were scrambling with tin cup in hand to stave off disaster. Now their yield is negative 0.01%.
Yes, a wonder to behold—but not one I can explain. Better its left to the experts in today’s bizzzaro world of maniacal central banking. That is, with the reminder that the ECB has now set its deposit rate at negative 0.2%, here’s how Goldman explained the Irish note miracle to the WSJ:
If “you buy short-dated Irish or French paper and pay less [than depositing at the ECB], you’re improving your net income, even if the yields are still negative,” said Jonathan Bayliss, a managing director for global government bonds at Goldman Sachs Asset Management in London.
That’s right, down is the new up. The price and yield of government bonds no longer have anything to do with risk or economics; it’s all about central bank machinations. Actually, it’s all about the speculator driven momentum surges that are triggered by central bank maneuvers.
As is well-known, Draghi’s “whatever it takes” pronouncement triggered the most blistering bond rally in recorded history. Leveraged speculators have literally made triple digit returns since July 2012 in the notes of still debt-besotted basket cases like Spain, Italy and Ireland.
Indeed, in its breathless reporting on the miraculous recovery of the European bond market, the WSJ noted that red-hot returns are still being earned two years after the fact—as Draghi hints ever more strongly that a tsunami of ECB bond buying is just around the corner. During the last 9 months alone, punters have made double-digit returns on the debt of Italy and Spain—both of which are barely treading economic water and sinking deeper under the burden of public debt:
Spanish debt have fallen to 2% from 3.71% at the start of the year….That has lifted total returns—which includes price changes and interest payments—to 13%. On average, Italian bond yields have dropped to 2.33% from 3.78% over the same time frame, generating total returns of 12%.
It’s not surprising, of course, that yield-parched investors are being virtually herded into peripheral sovereign debt. After all, if they happened to have more confidence in the AA rated, stalwart supplier of the world’s sweet tooth (Nestle SA) than in Europe’s socialist politicians, for example, they would be able to garner the grand sum 0.4% on its five-year notes.
So what you get is a vicious push-pull. The big time hedge fund gamblers pile on when they conclude the central bank is going to be buying or supporting a specific asset class. Then when bond prices start rising rapidly, more cautious institutions join the fray. In the instant case, for example, Spanish and Italian banks have brought nearly $500 billion of their own country’s sovereign debt since mid-2012.
The bank bid adds thrust to the momentum play, but it’s also telling. With their marginal cost of funds at the zero deposit rate, why would European banks not harvest this ECB enabled yield curve arb all day rather than actually engaging in the act of loan-making? And then, finally, any timid bond fund managers left in the world can either choose to be fired for failing to hit their benchmark or pile on, too.
The end result is the complete destruction of price discovery and the rampant mis-pricing of risk. Yes, in the case of Ireland, there has been some sparks of rebound with GDP up in three of the last four quarters and its peak unemployment rate beginning to recede. But its pre-crisis debt binge was so spectacular that it is still hopelessly buried in the residue.
After all, the EC fix did not involve debt repudiation or meaningful lender haircuts: It was just another giant exercise in the toxic Brussels alchemy of refinancing the debt, stretching the maturities and, just generally, kicking the can. So, yes, after Irish bank debt outstanding tripled in six years through 2009 to the astonishing sum of $600 billion or 3X GDP, it has been sharply reduced by the bailout. Still, it remains at a GDP ratio far higher than the US.
As shown below, however, this was essentially accounting legerdemain. The towers of bank debt just moved over to the government accounts—leaving Ireland’s debt to GDP ratio at 124%, and at a level 5X where it was in 2008 when the binge was cranking hard.
The problem is that on all the important economic metrics, Ireland’s economy is still smaller than it was in 2008. On the broadest measure, GDP is still 17% below its 2009 peak. Even in real terms, the Irish economy is no larger than it was in 2007:
Likewise, its unemployment rate has dropped from 16% to around 12%, but like in the US there is less to that gain than meets the eye. Ireland has experienced a huge reduction in its labor force including outmigration. The telltale evidence is in the figures for the number of people actually employed. That is still down by 10%. Similarly, industrial production is no higher today than it was in 2007.
Similarly, private final consumption expenditures have to barely returned to 2006 levels after a 15% decline from the peak:
In short, there has been no Irish miracle turnaround that would remotely warrant the massive bond rally that has occurred since the crisis—to say nothing of a negative yield on two-year notes. Instead, the crackpot financial engineers in Brussels have turned Ireland into a debt serf that, at best, may manage to tread water until the next global downturn puts the damper on its export recovery.
But here’s the thing. Virtually none of the punters who have heeded Mario Draghi’s word clouds actually own Ireland’s debt. They all rent it by the day.
That means that Irish two-year notes yielding negative 0.1% will be crushed on the sound of a single word. Nein!
When the Germans say no to massive QE, the two-year rip in peripheral bonds will become a monumental wreck. And the Irish taxpayers and economy will be left with a mountain of debt—public and private—that at last count totaled about $2 trillion on a $225 billion GDP. It can’t possibly be serviced. By David Stockman, David Stockman’s Contra Corner