In early October, the Italian government sold its first ever 50-year bond. The issue was not very large (5 billion euros), but still big enough to test investors’ reaction to such a long maturity and relatively low coupon (2.85 percent). Italy’s 10-year bond currently yields about 1.44 percent. The 50-year sale was a resounding success, as the Italian treasury received orders for more than 18 billion euros. This scale of investor interest was indeed surprising, given the precarious state of Italian public finances and a slew of data confirming the country’s poor macroeconomic performance (the economy will expand by less than 1 percent in 2016 and will not do much better in 2017).o
The 50-year bond is important for several reasons that could prove fateful for European finance. The issuance of such long-maturity paper sheds light on what key market operators believe will happen over the next few decades, and suggests potential sources of instability should financial developments deviate from business as usual.
Let us focus on three aspects of the transaction. First, the popularity of the Italian 50-year bond demonstrates that investors believe the risk of a large European Union member state defaulting on its debt is minimal – especially in the case of countries with a track record of cordial cooperation with the European Commission and the European Central Bank. Second, the bond’s pricing suggests that inflation is expected to stay close to zero for decades; this implies that investors expect that the ECB’s expansive monetary policies will soon shift to neutral and that the current monetary overhang (manifest in the large amounts of liquidity parked on current accounts) will be gradually absorbed.
Third, the 50-year issue indicates that Italy may have given up on shrinking its public debt, both in absolute terms and relative to gross domestic product. In this context, one may speculate that large debtors, to avoid future difficulties, may be considering the conversion of their financial obligations into perpetual, unredeemable liabilities. This would make the 50-year bond an intermediate step toward new issues of perpetual bonds with rather low coupons.
If these three conclusions are on the mark, we can expect public debt across the eurozone to be underpinned by sweeping guarantees. These will include expansionary monetary policy on demand, whenever investors begin to fear that governments may be unable to honor their financial obligations. Just as important, low inflationary expectations would imply that households will continue to fret about the future and therefore rein in their consumption.
If Italy’s 50-year bond is a telltale, it shows that investors believe most European economies are headed toward decades of stagnation, and that extensive bailout programs will keep governments solvent as long as they remain in the eurozone (and the eurozone does not collapse.)
However, this line of reasoning also raises a few questions, which in turn might disclose different scenarios. Why should governments float 50-year bonds and perhaps consider issuing perpetual bonds at a premium, when they save more than 100 basis points (or 1 percentage point) by selling 10-year bonds and keep kicking the can down the road? Perhaps it is because governments want to reduce their dependence on commercial banks and, more generally, on financial markets as reliable bond buyers. And if that is the case, why would commercial banks and financial markets change their opinion about government debt?
A related question is why should investors believe that the scenario sketched earlier – a frozen eurozone characterized by comprehensive bailout programs, privileged and complacent debtors and very slow growth – is going to last for the next half-century?
National governments, the EU authorities, investment bankers and asset managers seem to be spontaneously converging toward a common strategy. National governments realize that the eurozone is under pressure and that the euro is far from stable. Several countries blame the single currency for their own structural weaknesses and so-called “austerity” measures imposed by Brussels. The temptation to claw back monetary sovereignty is increasing almost everywhere.
The wobblier members of the euro area hope to shrug off fiscal discipline and finance bouts of public spending by printing money. Stronger economies hope to get rid of weak and unreliable partners. Should this instability turn into a crisis – if Italian Prime Minister Matteo Renzi loses the forthcoming constitutional referendum, for instance, and the government steps down – yields on bonds issued by troubled eurozone countries would probably shoot up and the possibility of partial default would no longer be remote. That means countries with shaky finances are right to take advantage of today’s low interest rates by rolling over their debt into very long maturities. In their view, the long-term picture is far less stable than the market seems to believe.
The European authorities, in turn, are only too happy to put some distance between themselves and profligate policymakers in the national governments – especially if this can be done without causing major shocks. The longer the maturities and the cheaper the financing, the lower the pressure on Brussels and Frankfurt to come to the rescue, through quantitative easing or a possible conversion of national government bonds into some kind of eurozone bonds.
Taking the bait
It is by now abundantly clear to all that the EU has failed to enforce budgetary discipline, that its plans to centralize fiscal policy must be shelved, and that its solutions to the financial crisis of recent years have flopped. The most likely exit strategy from this predicament would consist of three steps: introducing a bail-in principle for troubled banks, making sure that future increases in interest rates do not lead to total sovereign default, and abstaining from printing money and/or persuading commercial banks to buy more government bonds.
The first step has already been implemented: since January 2016, governments can no longer come to the rescue of troubled banks. Shareholders, bondholders and depositors with accounts exceeding 100,000 euros will have to take the losses if a bank defaults. As to the second step, one wonders whether it will be carried out quickly enough: proposals to transform at least part of national debts into EU debt guaranteed by the ECB are currently on hold. Step three has been announced, but not yet begun, pending the completion of step two.
Europe may be heading toward a scenario in which national governments begin to overhaul their financial position and brace for possible significant shocks to the euro edifice and in financial markets, having obtained the blessing of the EU authorities to do so. If this is true, why should investors take the bait and buy long-term securities bearing relatively low coupons? Do they really believe that the next decades will be marked by stability, and that a painless solution will be found to the problems that have piled up in recent years, guaranteeing a soft landing?
The most likely explanation is that asset managers are desperate to get decent returns from their bond portfolios. They are willing to take all kinds of risks to keep clients happy, lure new customers and cash in fat performance bonuses. This strategy could even offer satisfactory returns in the short run. Yet these portfolios will be vulnerable to future shocks and downturns, which will only encourage asset managers to be ready to dump their long-dated bonds before prices collapse.
The inescapable conclusion is that the rising popularity of very long-term and perpetual bonds is not a symptom of stability, but a sign that investors are so thirsty for high yields that they are willing to ignore risk. National treasuries are taking full advantage of these sentiments to shore up their financial positions, as they gird for future trouble and crises. Instead of safeguarding the future, these debt issues could make markets even more volatile, and possibly trigger deeper financial crises.
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