Investors rethink US/UK safety as debt surges
Mon Apr 5, 2010
By Richard Leong and Emelia Sithole-Matarise - Analysis
NEW YORK/LONDON (Reuters) - A surge in public borrowing in Britain and the United States has distorted historic market relationships and may have put to rest the long-held notion of risk-free U.S. and U.K. government debt.
For the first time on record, investors are demanding higher premiums on U.S. and U.K. government bonds than on debt issued between top-rated banks in the two countries.
This seismic shift along both sides of the Atlantic has turned the spotlight on the indebtedness of the world's No. 1 and No. 6 economies -- the legacy of expansionary policies adopted to combat recession.
What remains to be seen is whether this yield flip is an aberration, or a game-changer that permanently pumps up the relative U.S. and U.K. public debt cost versus G7 peers.
"Sovereign debt is not what it used to be," said Eric Green, chief U.S. economics and rates strategist at TD Securities in New York.
The latest warning sign for the United States and Britain is the yield inversion between so-called interest rate swap agreements and government debt.
Companies use these contracts to exchange fixed-rate obligations for floating-rate ones to manage changing cash flows and interest rates. They hedged $342 trillion (224.4 trillion pounds) worth of various financial products at the end of June 2009.
The rate for the company to receive fixed-rate cash payments in a swap contract is expressed at a yield premium or spread over Treasuries.
At one point last week, a company could obtain fixed-rate dollar payments at a yield nearly 0.10 of a percentage point below the yield on a 10-year Treasury note. By Thursday, the rate on fixed rate payments briefly turned positive to Treasury yields.
The yield inversion between swaps and government debt is seen by some analysts as a sign the United States and Britain could be following the same fiscal path as euro zone economies like Portugal, Italy, Ireland, Greece and Spain.
The euro zone market saw this inversion happen last year with Germany. Concerns about its soaring debt levels, and rising confidence among investors seeking higher yielding assets, saw benchmark Bund yields slip below 10-year euro interest rate swap contracts last May for the first time in the euro's lifetime. That reversal was short-lived and the spread is now rangebound above zero.
The dominant view is that the United States and United Kingdom will also see only a short-lived yield inversion.
There are many analysts who attribute the reversal to a confluence of "technical" factors including unwinding of massive bad swap bets, the sheer amount of new supply and the increased use of swaps to hedge new corporate debt.
"This is not a credit issue. It's mainly a supply issue," said James Caron, head of global rates research with Morgan Stanley in New York.
Since the outbreak of the credit crisis in 2008, U.K. gilt supply has quadrupled, while the outstanding amount of U.S. Treasuries ballooned by 50 percent to $7.6 trillion.
By comparison, the euro zone supply has risen by just over 50 percent to almost 1 trillion euros forecast for this year. That is largely why the 10-year Bund yield has been rangebound just below swaps since its brief inversion early last year.
INVERSION HERE TO STAY?
The yield inversion on the 10-year dollar swap and 10-year U.S. government note happened less than two months after the U.K. 10-year swap yield fell below that on 10-year gilts.
Part of the swap's yield premium reflected the perceived default risk of a counter-party, often a top-rated bank.
Thus, the inversion of these historical yield relationships bolstered the case for those who say investors are demanding more compensation to hold U.S. and U.K. government bonds.
"It's becoming an incredibly important barometer on sovereign risk going forward," said Joseph Brusuelas, President of Brusuelas Analytics in Stamford, Connecticut.
Still, most analysts argue that it is overblown to conclude U.S. and U.K. public finances have deteriorated so badly they are more likely to default than their countries' banks. The case of a government default has weakened since the two countries bailed out their banks just over a year ago.
"After all, if at the extreme, government default became a reality, what hope would there be for the banking system?" said Steven Major, a strategist at HSBC in London.
Morgan Stanley's Caron added if investors were fearful of a U.S. or U.K. default, the cost to insure their debt should have skyrocketed in the credit default swap (CDS) market.
The prices on U.S. and U.K. CDS, while edging higher in recent days, were far below the record highs seen during the global financial crisis.
Regardless of one's interpretations, the collapse in the yield gap between U.S. and U.K. swaps and public debt will likely remain in the near future as heavy government borrowing goes on.
"It is quite possible that the inverted swap spread...will persist for the next one to three months," HSBC's Major said.
On the other hand, technical factors could lead to a protracted inversion like the one seen in U.S. 30-year swaps. Hedging on exotic long-dated products has kept the 30-year swap spread from normalizing since early 2009.
(Editing by Andrew Hay)
01st April 2010
Treasury documents released under Freedom of Information last night suggest that the Bank was reluctant to sign up to the sale of 395 tonnes of gold at rock-bottom prices in a series of auctions between 1999 and 2002.
The deals, struck when Mr Brown was Chancellor, are thought to have cost Britain £6billion, almost double the £3.3billion cost of Black Wednesday in 1992 when the country crashed out of the European Exchange Rate Mechanism.
Senior officials are said to have warned that the timing of the sale risked losing money for the taxpayer.
Treasury ministers and Tony Blair previously told Parliament that the sale was made 'on the technical advice of the Bank of England'.
One crucial passage in the papers about relations between the Treasury and the Bank has been blacked out.
Liberal Democrat Treasury spokesman Vince Cable said: 'It has long been clear that Gordon Brown's gold sell-off was spectacularly bad timing, but these papers show the extent of the opposition from those who saw how much money his actions could lose the country.
'It is clear that the taxpayer is now footing the bill for the Prime Minister's refusal to listen to reason.'
The sale took place during a slump in world gold prices which drove its value to record lows. At the time City analysts warned Mr Brown against the sale.
The Treasury achieved an average price of just $275.60 an ounce. The price of gold has since quadrupled to $1,114 an ounce.
The documents show that Mr Brown made repeated efforts to persuade the Bank to agree a 'joint proposal' on the gold sell-off.
The Treasury made at least four separate attempts between August and December 2008 to persuade the Bank to sign up to the sale.
It is made clear that the Bank offered advice to Mr Brown in September 1998 but it was rejected. The bank is thought to have told Mr Brown to delay at least part of the sale until the price improved.
A source close to the Bank of England said last night: 'It was not our decision. It was their decision and we simply provided technical advice. Then it was up to them.'
Two days before Christmas 1998 - just a month before the sale was announced - a senior Treasury official wrote to the department's then permanent secretary Gus O'Donnell: 'The Chancellor is keen that officials at the Treasury and the Bank work together to produce a joint proposal. As I understand it the latest proposal is not a joint one.
'The Chancellor needs to know the status of the proposal, what the difficulties are in drawing up a joint proposal, how you think we can move forward in achieving a joint proposal.'
Three weeks later Mr Brown met the then Bank Governor Lord George for lunch to discuss the plan. But the outcome of the talks is unclear because the Treasury has blacked out a key section of the only note referring to it.
Lord George offered only the most lukewarm endorsement of the decision at the time, telling MPs it was a 'perfectly reasonable portfolio decision'.
If he had refused to agree to the sale he would almost certainly have had to resign.
The documents surrounding the gold sales were kept secret for years until the Information Commissioner ruled this month that they must be published following a Freedom of Information request.
Shadow Chancellor George Osborne said: 'Under questioning from David Cameron, Gordon Brown said he would be happy to publish the truth about his disastrous decision to sell off Britain's gold at the bottom of the market.
'Now we see a key passage has been redacted. What has Gordon Brown got to hide? After all, we can't get the gold back. If he doesn't publish the documents in full, people will suspect there is a cover-up.'
In a statement last night the Treasury said: 'The proceeds of these sales were re-invested in interest-bearing foreign currency assets. Other central banks have adopted similar policies.
'As a result of this, the Treasury reduced the risk of volatility to the reserves by 30 per cent.'
A Bank of England spokesman refused to comment.-----------------------------------------------------------------------------------------------------------------------------
further reading: http://www.zerohedge.com/article/uk-treasury-relases-foia-gordon-browns-1998-gold-sale-catches-tony-blair-lying-questions-us-