Where’s the Two-Headed Monster?

Little is more debated in financial markets than government finances and inflation. Nearly every client meeting, strategy discussion and media interview that I participated in over the past 18 months focused – at least partially – on at least one, if not both, of these topics.

Actually, many pundits seem to be convinced that lower public sector creditworthiness and higher inflation are inevitable parts of our economic future. Not surprisingly, many financial markets participants are therefore very concerned about the outlook for global treasury markets.

Although barely anyone still labels government bonds as “risk free”, they often still compose the ‘safe’ part of an investor portfolio. Not only because treasuries generate more stable returns, but also because they often print positive return numbers when most ‘risky’ assets print large negative drawdowns. Especially in periods of crisis, government bonds are therefore a good diversifier and capital protector.

The outlook for higher risk premia in treasury markets due to either lower government credibility or due to rising inflation expectations undermines the ‘safe’ credentials of government bonds. Thereby the base of many investor portfolios is undermined as it is nearly impossibly to find other assets with the same characteristics. Especially because risky assets (such equities, real estate or commodities) will often also perform negatively if public sector solvency is in doubt or inflation accelerates sharply.

As a result, the fear of the two-headed monster of sovereign default and inflation is easy to understand. However, this fear should not prevent us from carrying out a reality check on the likelihood of the monster manifesting itself. The first thing to notice is that the doomsday warnings on the future of treasury markets, which have been vocally expressed ever since the US Fed started its QE program in March 2009, have been more forecast than fact.

Even with rising budget deficits and debt-to-GDP ratios heading towards 90% in the US and Germany and headline inflation having increased in both countries to above their Central Bank’s targets, 10-year treasury yields are roughly unchanged from where they were in early 2009 (see graph). Both have therefore experienced few problems in funding themselves over this period. Over the last two and a half years these interest rates have basically traded in a relatively low 2.5%-4% band in the US and a 2%-3.5% band in Germany, and moved up and down on the back of cyclical momentum (stronger growth, higher yields and vice versa) and the (expected) direction of monetary policy (easier stance, lower yields and vice versa).

Interestingly, the latter stands completely in contrast with markets worried over government solvency and inflation, because if that had been their focus then higher growth prospects would have pushed yields lower (by reducing default risks) and an easier monetary policy stance would have pushed up yields (by driving up inflation expectations). The revealed preferences of Mr. Bond Market clearly suggest that some have been much too early to cry wolf.

Obviously, this offers no guarantee that the two headed monster will not pay the treasury market a visit at some point. However, it should remind everybody that it might be far less obvious that this needs to happen in the near future.

Both the US and German governments have earned credibility with a long track record of fiscal reliability and willingness to be flexible and take tough decisions in times of stress. Due to what are still significant output gaps in the US and Europe and a still impaired monetary transmission mechanism in both regions, persistent inflationary risks over the next 12 to 18 months are more contained than many fear. With many other event risks on investors’ minds (Greek restructuring, US double dip, Chinese real estate collapse) renewed ‘safe haven’ flows into to the two largest and most liquid treasury markets might well occur before default and inflation will be haunting these markets.