Cheeseburgers - the next legal tender?

This year the total amount of sovereign debt (that is national and state governments) that needs refinancing globally is estimated to be $3 trillion. In addition to that, the sums for future years are being added to daily by fiscal stimulus packages aimed at kick-starting waning economies. Taxable revenues are falling as unemployment is increasing - this past Friday saw non-farm payrolls in the US for December fall by over half a million for the second month in succession.

Also in the past week, investors chose not to take up all the debt on offer at a German Bund auction, leaving nearly €2bn of debt unsold. Across the board the price of insuring government debt is rising: it costs more to insure against US and UK government default with a credit default swap (an insurance policy against default) than against the collapse of McDonald's, the fast-food chain. This quirky situation is one of the easiest demonstrations of how the efficient markets theory that underlies our economic policy-making can be quite daft; any country with a central bank can always service its debt by printing money, and as of yet cheeseburgers albeit good value, aren't legal tender.

To be clear, however, investors have not sated their appetite for debt backed by strong governments. The "failed auction" was partly a quirk of the German bond sale process. Rather than holding a reverse auction for debts, it fixes a price. If debt is left unsold, it will try again on another day. It was certainly not good news, but is not a reason to panic. France, Spain and Ireland all held auctions after the Germans and these passed without incident (oversubscribed in some cases) while there was strong demand for Commerzbank's German-state-backed debt. Lenders still want large quantities of safe, liquid assets.

The municipal bond market in the US has not held up quite so well, and may well be a leading indicator of where some national governments may be heading. Rising bond expenses are forcing municipalities to postpone projects, with estimates that the backlog of offerings to fund public works has grown to more than $120 billion. Examples of project postponements are a growing subject category in local newspapers across the US (and around the world). The school district in Fort Bragg, California, a town of 6,600 located 170 miles north of San Francisco on the Pacific coast, put off construction at its high school and delayed a solar-power project after shelving a $7 million bond sale when interest rates jumped following the collapse of Lehman Brothers in September.

Worryingly the state of California, which if separated from the US would still be the 5th biggest economy in the world, saw its credit rating downgraded again last month (to A-). It now has the joint lowest credit rating of all of the US states, tied for that unenviable position with Louisiana, which more than 3 years later is still recovering from the devastation that was Hurricane Katrina. California's state shortfall will reach a record $41.8 billion over the next 19 months, and the State Controller has said the state could run out of cash within weeks. Consequently they may begin delaying tax refunds, student grants and vendor payments by the start of February if lawmakers do not resolve the States fiscal problems by then. Arnold Schwarzenegger has proposed to borrow $23.3 billion via the municipal bond markets to cover immediate liabilities, but the sense is that it would be impossible for the markets to clear that quantity of debt in any short time frame at any reasonable price.

The next stop for California, should the bond markets fail them directly, is not likely to be bankruptcy. They will almost certainly be tacked onto the growing list of targets for Federal level bailouts - Barack Obama is proposing that the Federal Reserve and the US Treasury Department together design a "funding backstop" for state and municipal debt that is similar to the Fed's program for commercial paper. "This new facility should be designed to protect taxpayer resources while ensuring that state and local governments can continue to provide vital services to their residents." said Obama. As a consequence the attractive yields on existing municipal bonds traded in the market should be a compelling alternative to US Treasuries, which as investors have been globally taking flight to their relative safety have seen yields drop precipitously. Nonetheless, given that California has a problem that is not isolated, and the US municipal bond market is close to $2trillion in size, it's disturbing to think how much could be tacked onto the overall US Federal bailout package, and the overall amount that will need to be raised via the bond markets to cover these liabilities.

To restate this; the UK is the worlds 5th largest economy (with GDP in 2008 at around $2.8trillion). California, if not part of the US would be the 5th biggest economy. Although it's not a comparison of like-for-like, as California does contribute to national tax revenue in the US, it is a scary proposition that an economy the size of the UKs cannot fund itself directly, and its liabilities are going to be assumed at a national level.

The US has a financing requirement in the next 12 months of $2trillion, based on current estimates. I think that figure will realistically be higher, as they grow the number and scale of their "funding backstops" to corporations (GM/Ford etc), to agencies (Fannie Mae, Freddie Mac), and to a growing number of municipal authorities (California, New York etc.). The $3trillion funding tag for sovereign borrowers globally this year, is in my view more likely to be closer to just the US portion of the funding requirement. Globally the real number could be substantially higher.

At current yields on benchmark government bonds in the "strong" nations of the world (US, Japan, Germany, France, UK etc.) the current cost of funding available is strikingly attractive. The US 10yr Treasury is trading at a yield of well under 2.5%, 10yr UK Gilts are yielding little over 3%, and likewise 10yr German Bunds, so borrowing costs at a Federal level are perfectly affordable. Given the asset price erosion across the board - stocks, real estate, corporate bonds etc. - it is understandable that there has been a "flight to safety" into government backed assets. However, given the scale of funding that is a requirement globally over the coming years, there must be a saturation point for investors. The ever growing list of liabilities being assumed by these governments will need to be accounted for in terms of either much higher yields or a complete unwillingness or even inability to invest.

In the Eurozone, there are similar situations where at a Federal level (i.e. from Brussels) there may be calls for bailouts of some of the peripheral, and even not-so-peripheral states. Already Italy and Greece, who were largely scale funders through the international bond markets are struggling to tap the markets at either reasonable rates, or at all. They may find that the value of their EU membership is greater than was previously thought if the likes of Germany, France and the UK play the role of providing similar "funding backstops" to those being proposed in the US. Perhaps more worrying about the European situation is that Italy and Greece, unlike California don't seem to be producing companies like Silicon Valley can in California, the Apples of the world; so tax revenues that would be used to pay off future liabilities will not be as forthcoming. For example the protracted process of privatising Alitalia will cost the Italian taxpayer more than Euros 3bn in written-off debt. The number of layoffs across the country in December was up 528% on last year, with the central provinces of Lazio and Abruzzo the worst affected; everything from steel to textiles is showing signs of weakness. In Greece, recent riots and proposed union strikes are commensurate with exponential rises in government bond yields. Greece has to rollover debt in 2009 that is greater than 20% of 2008 GDP, and the credit insurance market is pricing in a default probability of close to 20% over the next 5 years. It's highly questionable as to whether they can do this, without some explicit guarantees from their EU brethren.

As much as this is all very gloomy, the big issue I am looking to understand is why the yield on government bonds in "strong" countries is continuing to lower itself when the liabilities side of their collective balance sheets is growing and worsening at a pace of knots. In December the yield on 3 month Treasury Bills (i.e. short term US govt. debt) actually dipped below 0%, meaning that investors were actually willfully losing money to invest, but doing so on the basis that the speed of their loss would be slower than on any other store of value they could think of. In the future I would say that there is a great likelihood that as these same governments tried to stave off deflation, they will look at policy actions that could be hyper-inflationary further down the road. If government debts become so large, one easy way to reduce their cost is to pay bond investors with money the government has printed. In some cases this may be the only policy action that is left available to avoid default.

The fact that yields on government debt in "strong" countries are so low, is a consequence of how bad the world investment community views alternative asset classes. A taxi driver once said to my Dad as he jumped in a taxi to head to the airport in Las Vegas,

"How did you do?"
...to which Dad said: "O, I'm not really a gambler"
and the taxidriver said:
"Yep, I hear you. The best you can do is to lose slowly"

That seems to be the manner of thinking of those jumping headfirst into the apparent safety of the worlds government bond markets. But even the non-gamblers may be wrong.