The Shape of the Global Bond Market
09/24/2012 9:30 am EST
The US Federal Reserve and the European Central Bank have made some major announcements in early September that change the face of the global market. Now it's time to see where opportunities exist moving forward, observes Don Quigley of Artio Global Managment.
Gregg Early: I am here with Don Quigley head of the Artio Total Return Bond Fund (BJBGX) at Artio Global Management.
Don, what I thought we might want to start with here, seeing as you're looking at most of the bond markets around the world is we've recently heard from Ben Bernanke at the Federal Reserve, and a new round of QE3 it is starting. And Mario Draghi had a speech just a little while ago talking about what Europe's plans were for their bond markets. How do you see those two recent events playing out in the global bond market?
Don Quigley: The way I would look at it for the Fed: Bernanke has truly signaled that he is going to try and keep "risk on." He wants the financial asset markets to be driven up.
Yes, he can talk about keeping interest rates low. But it doesn't have to hold that interest rates have to dive because the Fed is buying fixed-income instruments.
What he's almost doing is pushing investors out into riskier products. For us, we think there's an advantage, say, going into spread products. That would be things with a higher yield than Treasuries. Whether it's corporate bonds or market-backed securities or commercial market-backed securities.
Switching over to Draghi, he is trying to take away the tail risk within the European situation. Obviously, Greece is a mess, and Spain has some dramatic problems. What he's trying to do is say, "Look, it's not going to get that bad because we will do enough." He basically said, if we have to do something, we'll do it and we will do enough to take care of it. Both of them are basically saying we're not going to let anything bad happen.
As a bond guy, you always have to be a little bit skeptical because at some point in time that the inflationary pressure comes on. Remember, Draghi has not turned on the printing press yet. Bernanke has.
He first signaled that a country, let's take Spain, has to agree first to some conditions in order to get the ECB to start buying their bonds and drive their interest rates down. They'll have to go through a conditionality test. Basically, they're going to have to give us some serenity-fiscal sovereignty, let's call it. For a government that's a hard thing to do.
Our expectation is that the Draghi thing isn't going to come into effect yet. You almost have to get Spanish yields to get pushed back out so that the Spanish government gets panicky. Then, when they're panicky, they go to Draghi and say "Help us," and yes we'll give up a little bit of sovereignty.
That's when you're going to see the ECB come in, and they'll come in in a big way. There's a lot of things going on in that market but you almost feel like before Spain is going to concede; there's going to have to be some market pushback from the rally that's taken place, especially on Draghi's news. It's something definitely to watch. It's very interesting times in the market.
Gregg Early: So the inflationary effects are more here, and what we're looking at in Europe more or less is that the ECB needed to be more of a central banker for all of Europe, as opposed to each country having their own say on how they ran their monetary policies. They're kind of forcing more unity within the central bank structure. Is that what Draghi is attempting to do?
Don Quigley: Well, the ECB was the central bank for all of Europe, but basically what each country was able to take advantage of in the past is they could get these really low rates because they now had a hard currency [the euro] and a credible central bank, as opposed to the Central Bank of Italy or whatever, and they could take advantage of that.|pagebreak|
Investors crowded in. Italy rallied from a spread of 700 basis points over Germany in 1995 to in 2003 or 2004 it was ten basis points wider than German rates. That's now changed obviously. There's more credit risk now.
It's gone from being a monetary policy issue to a fiscal policy issue. The ECB can only control a certain amount. What they're trying to do is say, "Look we're willing to buy your debt to keep your rates down to help you get yourself out of this situation, but you have to do more on the fiscal side." Meaning you're going to have to go through more austerity.
That's very difficult for a politician to swallow or to be told, especially with a country that's already going through a lot of pain, let's say Spain with 25% unemployment. The fact that you're going to have to make more budget cuts,. that's a very painful thing in a democracy to have to accept.
So that's where I'm coming from on how Draghi is trying to control it. He's not really worried about the inflation. Just remember Draghi hasn't hit the printing press button yet. It's only once Spain reaches their hand out.
Also they are saying they're going to sterilize their intervention; meaning yes they're going to buy Spanish debt, but they're going to be buying out older-term paper to make it so that the net amounts on their balance sheets are smaller. The markets aren't so sure that that sterilization is as credible as the ECB would like them to believe, however.
Gregg Early: Is part of this complication why in your funds, the countries you're carrying seem to be more emerging-market countries, or non-European countries I guess? Because you have Australia I as one of your top ten holdings, and Canada, Mexico, Brazil. Is that kind of the rationale there? Why don't you tell me why you're holding those as opposed to the European countries.
Don Quigley: Of course. We do think that the Eurozone right now is kind of a wild card. It's certainly put to bed yet. All the problems are not solved. You can argue the tail risk has gone down for the next six months to a year, but it's not solved.
Now going to Canada and Australia, here are two countries that we believe have much more credible balance sheets. They've done a really good job. The Canadian banking system is in terrific shape. Australia has a very good balance sheet; their banking system is in good shape.
It's not the same kind of risks you're getting in the United States where we're continuing to run up a huge deficit, the debt's becoming more and more of a problem. Our political will just doesn't seem to be able to face that. Here are two countries that in the longer term are going to be beneficiaries of that. We think their bond markets are more credible. Their currencies are going to be more credible in the long term for that reason.
Going to Mexico and Brazil, now I can't say Mexico and Brazil have better metrics all the way around than the United States or the Eurozone as a whole, but you look at them and say on a risk-adjusted return we're much more comfortable there than in the United States.
In Mexico, their central bank has done a great job. It's an economy that's been doing very well. It's got the narco terrorism problem; it's undeniable, but that gets a lot of headlines-it's easy to talk about and report. But their economy is still chugging away. They've got, like I said, a credible central bank and fiscal policy has been credible. Their metrics are much, much better than they were.
Brazil is the same. They have much higher rates than what you're getting in the United States, and yet you're able to achieve what we think is a continual good feeling coming from their fiscal position that they're going to manage themselves credibly.
Yes there are some barriers to entry to get into Brazil but we've been in those bonds for a long time. We're able to hold them continue to clip that coupon and all that extra yield really does work out for an investor. You can get the bonds we hold which are on the shorter end of the curve, around a two-year, we're getting over 7.5% yield. Well you're not getting that kind of yield in the US, so we think that's kind of attractive.