Little cheer for bond vigilantes

Published on the Malta Today¸ issue 15th December 2010

Finally it is upon us. Nearly all the investors are smarting up for the lush parties to kill the terrible times we have faced of late. This is when all the brokers¸ hedge fund managers and bankers start budgeting (like our parliamentarians) on how best to spend their annual bonuses and increased honoraria.

Now that it’s December¸ the investor community is hoping for better tunes to sing their blues after a dull session since the 10 year bond markets are certainly not humming. Gone are the days when the severe weather that is currently hitting North America and parts of Europe herald a time when snow blesses the countryside and houses with a beautiful and peaceful white sheen. Christmas decorations may be decking offices but the flashing lights will do little to lift the spirits of bond holders. This is not to forget the European workers who have seen their consumption patterns and lifestyle change radically in the face of austerity measures. Can bond lovers gloriously sing the famous Irving Berlin masterpiece “White Christmas “and herald a new era of stabilization? Possibly yes- but only if one contemplates a revival of the currently sluggish US markets .Will 2011 be a “White Christmas” linked to a swift revival of manufacturing in US .Can  domestic growth materialize in the short term to help ease the nasty unemployment problem in some economies?

The future is not easy to predict but we can instead be cautious not to fall to temptation of higher inflation. Taking a cue from Homer’s epic poem Odysseus we can perhaps learn from the success of Odysseus who knowing his limitations took preventive measures against succumbing to the siren’s lures. Continuing with the example of Odysseus who knew his limitations and wisely took effective measures can the bond market likewise brace itself to buttress a wintry weather ahead? Taking precautions bond holders may still enjoy seeing the yield curve increasing which as we all know will penalize repayment efforts of so many sovereign countries indebted to their hilt. The siren song of inflation creeping in is to be avoided and we already see it raising its ugly head in China .

Yesterday’s Sirens are the investors and traders of the global bond market¸ who lure nations into tapping abundant credit at low rates when times are good. But how can the threat of ever increasing 10 year bond yields threaten recovery prospects of fragile euro countries. Is there a effective surgery to resuscitate the patient. Many are hinting that the only plausible solution to saving the Euro under such dire times requires fiscal union. The one -size- fits- all solution of a fiscal union will definitely kill the financial services industries of emerging economies in Europe -ours included. Critics of a fiscal union will in reality merely push the problem somewhere else and could fester strident nationalism. While this is resisted by many¸ realistically it is the one who is paying the Piper who may eventually set the rules for the debtor countries to accept a fiscal union. In this context we see how repayment of debt by fragile EU members is directly affected by their higher cost to borrow.

Thus the yield spread on 10 year Spanish¸ Belgian and Italian government bonds over German government bonds increased to a euro era record¸ while the cost of insuring Portuguese and Irish government bonds against default also hit a record high.  Greece has already become a junk bo