The Sovereign Debt Cycle Continues

Despite the depressive sovereign debt looming above our heads, the S+P 500 leapt 19 points overnight to 1277. Commodities were also flying with gold up about 2.5% and silver having its biggest move in over three years, up over 6%.

Most market pundits are pointing to the fairly healthy Institute for Supply Management (ISM) manufacturing figures that came in a bit better than expected (up 1.2 percentage points at 53.9%). But the market was already up strongly before those figures were released.

I can’t be sure… But I suspect the dramatic change in the composition of the US Federal Open Market Committee (FOMC) board could have something to do with the surge in equity and precious metals markets.

Three new doves on the board of the FOMC have replaced three hawks. So now the board is stacked 9-1 in favour of loose monetary policy going forward. What are the chances the Fed will print some time in the next six months now? Pretty high I’d imagine.

Doves still in the voting majority


It would be difficult for them to pull the trigger now because equity markets are rallying strongly and economic figures are picking up, so I don’t think they will print in the next couple of months. But with the huge amount of sovereign debt due to be rolled over in the next year I think money printing is the only way they will cope with it.

My eyes nearly popped out of my head when I read on Bloomberg last night that “Governments of the world’s leading economies have more than $7.6 trillion of debt maturing this year.” Yes you read that right. $7.6 trillion.

$3 trillion of that belongs to Japan and $2.8 trillion to the US.

G7 aggregate debt principal and interest

G7 aggregate debt principal and interest
Click here to enlarge

On 29 December Italy auctioned 7 billion euros of debt, which was less than the 8.5 billion euros targeted by the Italian government. That’s not a very good start. Italy alone has to refinance $428 billion of securities this year with another $70 billion in interest payments.

If Italy struggles to reach its target of 8.5 billion euros just a few weeks after the European Central Bank (ECB) lent an “unlimited” amount to banks for three years via the Long Term Refinancing Operation (LTRO), how on Earth are they going to refinance $428 billion with 10-year yields at 7% and an economy that is keeling over into recession?

Before we can make any judgments about any possible money printing from the US Fed, you need to know what effect the LTRO will have. (I.e. the three-year loans worth US$641 billion that ECB recently made to over 500 banks in Europe.) Will the unlimited lending by the ECB filter into the sovereign bonds and therefore help with the upcoming mammoth task of refinancing?

I don’t know the answer… But banks have been dumping sovereign debt onto the ECB by the bucket load and I don’t think they are about to reverse course for the few extra basis points that can be made from the carry trade. But there is pressure being applied by the ECB and governments to use some of the proceeds from the three-year loans to buy sovereign debt.

Of course it has had a big effect on the debt under three years duration because the banks can easily match out their three-year loans with this debt. We have seen a dramatic fall in the last few months in this part of the yield curve in Europe. For example in late December 2011, the Spanish Treasury sold 3.7 billion euros of 3-month paper for 1.735%, after an average yield of 5.11% in November, at a bid-to-cover ratio of 2.9, up from 2.8.

The 6-month bill sold for an average yield of 2.435%, down from 5.227%, with 1.92 billion euros sold and demand outstripping supply by a factor of 4.1, after 4.9 a month earlier.

But when you look at the 10-year yields in Italy you see the same high levels near 7% as we saw prior to the LTRO.

As always the constant interventions in the market have unintended consequences.

If the ECB have forced all of the demand into the front end of the yield curve due to these three-year loans, does that mean the long end of the yield curve will suffer more than it otherwise would have?

Does that mean we will see a very steep yield curve even though Europe is in recession?

Will this then force each government to refinance with very short-term debt rather than long-term debt? Meaning they will need to refinance larger and larger amounts each year until the whole thing blows sky high?

A recent article on outlined the shell games involved with the three-year loans.

Italian banks have been issuing bonds to themselves and then having those bonds guaranteed by the Italian government, so that they can use those bonds as collateral at the ECB for three-year loans. The mind boggles.

Most of the money that was lent out has been redeposited at the ECB. So as the new year gets underway the most important thing for us to keep an eye on is movements in this money deposited at the ECB. Will it sit there as a capital buffer for banks like we have seen in the States or will it be put to work?

If the banks prove gun shy in loading up on sovereign debt with this new money then we may see the US Fed step into the breach in a few months with printed dollars.

Either way, the market seems to be feeling confident that the mountain of debt will be refinanced somehow, so why not start buying ahead of the party?

I can’t say that I feel like such a Pollyanna.

Murray Dawes
Editor, Slipstream Trader

Publisher’s note: Murray’s latest video, titled: “How to Trade Safely in an Extreme Market” is now live on YouTube. It’s not very often a pro-trader will admit to missing out on a potential half million dollars in profit because – in his words – he got greedy. But that’s exactly the sad and sorry tale Murray tells about his exploits during the Global Financial Crisis – in this brand new video message. If you like Murray’s videos you’ll love this one… you won’t believe how his fortunes changed (literally) in the space of four hours, one night in September 2008…

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