Fixed Income Roundup: No Consensus on Returns and Risk

As I have stated for the previous two months, investors and, consequently, journalists have largely moved on from the European Sovereign Debt Crisis. While in the last week fears of Spain’s mounting economic problems — as logged by feet-on-the-street protests, uncertain statements from the Spanish government, and increasing bond yields — have seemingly reinvigorated fears of a European implosion, the fact remains that investors are emphasizing other things. Furthermore, there seems to be no global consensus on what the direction of returns and risks will be. The following important stories emphasize this point:

• My feeling as to the most important story of the past month is the increasing amount of primary market debt financing done by European businesses. Historically businesses looked to intimate banking relationships in order to raise capital. Unfortunately, the result of this incestuousness is that sovereigns, banks, and businesses in Europe have highly correlated risks and returns, which has been a major contributor to European economic instability.
• It’s official! Japan is the first major nation allowed to buy Chinese government debt, as described in the 13 March 2012 edition of the Wall Street Journal. What makes this interesting is the enmity historical exists between Japan and China, dating back to the two Sino-Japanese wars. I suspect this is an indication of China’s emerging geopolitical strategy to secure its seaways by engaging one of the United States’ major allies. Meanwhile, both China and Japan were initially opposed to buying into EFSF bonds last autumn but have now stated their interest in them. What changed? And last among China news is there declaration, essentially, that “if you can’t beat them, then join them,” in which China is going to formally recognize its shadow lending sector.
• Though this could just as easily qualify as a story of bad ethics, the revealed corruption involved in the calculation of the London Interbank Offering Rate (LIBOR) means that there is an opportunity for a less opaque, less subjective replacement for this important benchmark rate.
• Stress tests for banks aim to provide a prospective, rather than retroactive, evaluation of risk. Good news of strong stress test results amongst U.S. banks was shared by many institutions, including JP Morgan which scooped the Federal Reserve.
• A new head on the hydra that is the European sovereign debt crisis, Spain, is threatening financial market peace. At the heart of the issue is which time scale should be used to evaluate the quality of policy prescriptions? A long-term focus calls for austerity and likely economic strain. Whereas a short-term focus has no austerity, less economic pain, but a likely debt default in the future. Especially interesting in contrast were the comments at the end of March by ECB President, Mario Draghi, that the worst of the European sovereign debt crisis was over.

For more news and trends, visit the Fixed Income Community of Practice.