Don’t Worry About Sovereign Bonds…

Blain’s Morning Porridge – August 1^st 2023: Don’t Worry About Sovereign Bonds…

“I would like to come back as the bond market. You can intimidate everybody.”

Everyone seems worried about the sustainability of Sovereign Bonds in terms of rising rates, interest burdens, debt quantum, and who will keep buying. Relax. Bonds have weathered worse. But there are ways to use Sovereign debt better.  

Global markets love to scare themselves. The latest shock-horror going to crush us all is the Sovereign Debt burdens of the big western economies. It’s going to be horrible say the papers! Here is a selection of headlines from recent days:

• Bank of England set to incur £150bn loss from bond sales after interest rate rises (Guardian)
• Britain’s debt pile outstrips EU as Bank of England prepares to raise rates (Torygraph)
• Traders Brace for $102 Billion Wave of Treasury Bond Sales (Bberg)
• US Racks Up $652 Billion in Debt Costs as Rates Hit 11-Year Highs (Bberg)
• Unsustainable debt. Italy’s EU funds bonanza hits the rocks (Rueters)

These all sound terribly frightening, but they are all, pretty much non-stories. Just how much should we worry about indebted some nations are? Or should we calm down, consider carefully and make some smart decisions. Experience has taught me there is lots of angst around Sovereign debt, but much of it is misplaced.

Too much debt is a massive problem for households and corporates. They have to earn the dosh required to pay debt down. As interest rates rise, they have to find more money to pay increased interest rates. There is an old adage: “raise money when you can, not when you have to”, which boils down to being smart about building cash piles before increasing financial stress makes it impossible to do so.

The problem for central banks, and by extension national treasuries, is very different. They have the keys to the money. No nation with its own currency (and printing press) will default. There are…. “consequences” of printing money, relating to inflation and currency. This is where I remind readers of my simplistic “Virtuous Sovereign Trinity” theory: a country with a stable currency, a sustainable bond market and competent politics will likely thrive, but if any of these three legs wobbles, the collapse can turn catastrophic very quickly.

We came close to it last year in the UK. Liz Truss and Kwasi Kwarteng were absolutely right the UK needs growth and productivity gains, but their plan to achieve it through massive spending was sprung on unprepared markets, un-costed, unplanned and unravelled the UK’s financial reputation over the course of the chancellor’s short speech. Political competency went out the window. In order to rebuild confidence the next government under Sunak had no alternative but to embrace the crippling orthodoxy of austerity spending – which we know doesn’t work, but makes the numbers look a little less unbalanced. (But, it conveniently plays to the economics of the libertarian right.)

Yesterday I saw a post asking how insane it is that US Government interest payments has jumped from $500bln in 2018 to nearly $1 bln in 2023 on its $24 trillion of net-public outstanding debt. It’s apparently 20% of US government tax revenues, and more than the $850 bln the US Government spends on defence annually! You can just imagine Republican Senators and MAGA reptiles gagging at the insult to the American people that their taxes are going to bond holders..!

Actaully, its simple maths (note to Americans: its maths, which is short for mathematics. It is not Math.) The average rate on US debt is 2.76%, up from 1.80% last year, but the Treasury will be paying interest at the rate it issued the debt, not the current yield (unless its inflation linked, or they “swapped” the liability into a floating rate.) Over time the rate the govt pays will rise reflecting low coupon debt maturing.

Even the 20% of tax revenues spent on debt servicing is not really a problem. The government repays maturing Treasuries by issuing new debt. Tax revenues cover the interest payments. When interest rates are high, the amount of tax spent on servicing debt is high – but it’s been 20% before. In 2021, before rising rates, it was just over 8%. The US can still buy the Army, Navy and Air Force new toys through borrowing – as long as investors have confidence in the nation.

The reality is market is ready for the $102 bln quarterly refunding – many now expect a Treasury rally as rates start to fall. Yet, in total the US will raise around $ 1 trillion this quarter as it addresses the rising federal deficit and rebuild its piggybank Treasury General Account, the cash buffer which was run down pre-debt-ceiling crisis. It sounds like an awful lot of money to be repaid in terms of interest and principal.

But here’s the thing. Real interest rates on Treasuries across the curve (the notional cost of US borrowing) remain (marginally) lower than inflation. Thus, it actually pays the US government to borrow! US Sovereign Debt may be 122% of GDP, but after inflation the US is paying less for more debt in real terms! There is another old adage: debt can be inflated away.

I am not going to panic about US debt. Yet. (Maybe later.) There is, as yet, no alternative to the US dollar in global trade, and nations seeking to invest their dollars have little alternative but the liquid Treasury market. Why might that change? Never underestimate the third leg of the Virtuous Sovereign Trinity – Politics. It’s hard to perceive much hope in any of the political choices in the US at present.

Meanwhile, back in Blighty, we had some extraordinary headlines across the UK hi-brow press about how much the Bank of England has lost as a result of quantitative tightening (QT) – selling the bonds it purchased during QE (quantitative easing). The Old Lady of Threadneedle Street held £875 billion of Gilts it has purchased under QE at the end of 2021. It still owns £800 bln of gilts – according to the bank they have only sold £26.5 bln of Gilts under the announced £80bln QT target sale programme. (The rest matured.)

Yet some of the papers reported the losses on the Gilt QE portfolio as around £150 bln – which papers from the Torygraph to the Guardian say will directly impact UK current spending, causing spending to be cut by an equivalent amount. Hah – it’s the difference on realised and unrealised losses. Through the 10-years of QE the Bank made around £124 bln from falling interest rates – which it gave to His Majesty’s Treasury. The reality is the £150 bln headline number for Gilt “losses” is what the loss will be if it sells down its whole £800 bln portfolio of gilts at today’s market prices – which is simply not going to happen.

As for the headlines about the level of UK debt outstripping EU debt.. well… Bollchocks! The UK’s debt stands at 101% of GDP – which is less than any G7 nation except Germany. And….. UK inflation is higher, so in real terms our debt is actually cheaper. (I wonder if I will be able to explain that to Chancellor Jeremy Hunt?)

Now the quantum of sovereign debt can’t simply be ignored. When should we panic? Is it when debt to GDP exceeds 100%? The economists Reinhardt (x2) and Rogoff said economies will lose up 33% of growth when GDP exceeds 90%. Data from the US supports this thesis, pointing to crowding out of investments into the real economy.

Maybe there is a simple solution to all this. Over the 13 years of QE, Global central banks pumped around $20 trillion of cash into the global economy. Around the globe central banks hold trillions of sovereign debt (with large unrealised losses) from QE. That debt is effectively national borrowing. Each time a bond in the portfolio matures the treasury has to refinance it by raising more debt on the market..

I have a modest proposal. It could be repeated around the globe. The UK treasury will offer The Bank of England a coin (a ZONK, minted in something special) with a face value of £785.3 Billion representing it’s whole Gilt Portfolio. The debt will then be written off by Treasury, reducing the UK’s debt-to-GDP ratio to somewhere around 60%.

Why would it be a problem? The actual money created by QE purchases is already in the system. The inflation generated by QE  is apparent in inflated financial asset prices. The Zonk could sit in pride of place in the Bank of England’s museum. It would be worth £800 bln, but utterly illiquid. I a few centuries inflation will have made it a rounding error on the balance sheet.

Worth thinking about…. Over the QE/Covid era we learnt some very interesting things about the possibilities of debt. We discovered the markets were ambivilant about central banks effectively directly creating cash and funding governments. What went wrong was how the money all went into inflating financial assets. What if that money had gone into real public assets like railways that worked, watersystems fit for purpose, a health service that delivered.. Just asking the question… I think it can be done.. (And I didn’t write New Monetary Theory once..)

Five Things to Worry About Today

WSJ                 The Benefit of Owning Stocks Over Bonds Keeps Shrinking

FT                    El Erian: Market optimism about convergence in the global economy is overdone

Torygraph        Over-compensating Bank of England risks crashing the economy

WSJ                 Europe returns to timid growth, but bigger headwinds loom

BBerg              BP Returns More Cash to Shareholders Despite Profit Miss

Out of time, and back to the day job..

Bill Blain

Strategist – Shard Capital