The crisis in the Eurozone, and crisis is now the appropriate word, is entering a new phase. Italy has been under attack in the bond markets for about a month now and today has a disastrous 6 month bill auction. Perhaps more concerning is the recent failed German bond auction. While a failed auction can happen from time to time especially in Euro markets, its timing could not be worse. It is clear that investors are completely abandoning the Euro markets in favor of US Treasuries, Japanese, and even British debt. Rather than receive a small, but “safe,” yield from German Bunds investors would rather keep their cash. Truth be told German debt is no “safer” than Italian, French, or even Spanish debt. Germany has a large current account surplus which theoretically keeps investment flowing into Germany, but there is no rule that says those funds have to go to Bunds. All of this shows the perils of a sovereign nation running a budget deficit. Deficits can be maintained as long as investors are willing to fund them, but there is no guarantee they will. The Euro complicates matters because, as I have discussed earlier, a European country can not monetize its debt (print money to buy its debt as the US Treasury has been doing).
What is really troubling for the long term is market expectations. Everyone under the sun seems to think that once the 10 year yield of country X goes over 6-7% it is unsustainable. Italy is there, Greece is there, Spain is flirting with that level. The pundits seem to be ignoring the fact that even in the mid-1990′s a 7% yield on a 10 year Bund, Treasury, Gilt, etc was nothing unusual and in fact was the norm. Let’s also ignore the fact that a US Treasury bond yielded double digits for most of the 1980′s. So the markets are telling us that if interest rates return to historic norms rather than the unusually low rates the central banks are forcing on us now, debt levels become unsustainable. Let’s also point out that Italy is set to balance its budget in 2013 (as opposed to 2020-the soonest anyone is talking about balancing the US budget) and is running a deficit of about 4% of GDP (as opposed to 9% in the US). I agree with the pundits when I say that debt levels are unsustainable, but I would argue they are unsustainable now for the entire developed world, US, Germany, and Japan included. Germany is starting to get hit because of their connection with the Euro, a completely unsustainable experiment. It is just a matter of time before the US and Japan start to suffer a similar fate. However, the US and Japan can print money to make their debt smaller as a percent of nominal GDP. In fact the US Federal Reserve has mentioned that they should perhaps target nominal instead of real GDP. This completely ignored tidbit is one of the biggest predictors of the future policy that I have seen in because it demonstrates that heavy money printing is going to be with us for some time. Think about the implications. If real GDP grows at a 0% rate, but you increase the amount of dollars in circulation by 10% and prices, wages, and the like also increase by 10%, GDP in nominal terms will increase 10% even though actual output and consumption is flat. According to the Fed’s proposed new measure growth is 10% rather than 0%.
At this point we are staying away from sovereign debt of any color.