Friday, October 31, 2008

The Debts of the Spenders: Bears Will Engulf Govt Bond Markets

All over the world governments have collectively spent massive amounts of money to support ailing sectors of the economy - exporters, insurance, banks, autos, homeowners, etc. However, nothing is free. This money will have to come from somewhere. The most likely sources of short term funding are the sovereign debt markets.

Government bond buyers rejoice! This is becoming a buyer's market.

While central bankers control short term interest rates - the infamous rate cuts so widely discussed in the media - the market controls longer term issues. Interest rates on 20 and 30 year notes are expected to soar in the future as governments continue to flood the markets with paper and provide aid to everyone except the taxpayer. Government battles against deflationary demons of their own design are even now rousing the inflationary bears from their slumber.

The US lacks a sufficient number of primary dealers to act as intermediaries in bond distribution even as Treasury auction schedules have increased. 4 have already passed on out of 20 - Washington Mutual, Bear Sterns, Countrywide, and Lehman Brothers have all either declared bankruptcy or been absorbed by more politically connected rivals. Moreover, the remaining bond and fixed income desks have been decimated by round after round of layoffs that have also affected the greater financial sector

Western Europe is in even worse shape. While the ECB, the fiscal body of the EU, can set interest rates, it is powerless to affect greater flows of monetary capital. Why?

Because there is no such thing as a "Euro bond". Individual member states continue to issue more and more bonds. Individual states such as France, Germany, and Holland have been the largest instigators of bailouts. Other nations such as Spain and Greece have not followed suit because their banks were too small to attract much investor notice to begin with.

This lack of coherent fiscal and monetary policy is straining the delicate balance upholding the union. Under the Maastricht Treaty, members are supposed to maintain fiscal deficits at no more than 3% of GDP. Even if Brussels were to tinker w/the figures, the structural cracks will eventually overwhelm a fundamentally flawed system.

I find it unlikely that the EU will survive in its present form within 5 years.


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