Evercore Pan Asset

For some time we have been advising clients to avoid investing in Western government bonds. The governments that have stretched finances have been subject to crises of confidence in bond markets from time to time, leading to capital losses. There are now plenty of sceptics about Icelandic, Irish and Greek debt, and a growing band of worriers about Spanish, Portuguese and even Italian. The governments that are thought to be better placed financially have offered very low interest rates by historical standards.

This week it was the turn of the stronger sovereigns to face the market’s ire. As we feared, you do not become rich or stay rich by lending to the US or German governments for 10 years at less than 3%. The long period of artificially low government borrowing rates has been brought about by two main developments. The first has been the decision of western authorities to have very low official interest rates, in response to the Credit Crunch and in recognition of the weaknesses of the banking system in increasing credit. The second has been the decision of the US and UK authorities to buy in unprecedented quantities of their own bonds to keep prices high and yields low. Even the European Central Bank has joined in on a much more modest scale.

The markets now sense that these policies are unsustainable. There have to be limits to how much debt the US and UK can buy in. If authorities print too much money it will be inflationary, which will also be damaging to fixed income bond prices. As economic recovery gets underway so authorities will need to follow the example of the Indian and Chinese, and raise short term interest rates to more normal levels.

The rate of interest the Germans have to pay has risen mainly because the German government and economy is locked into the Euro scheme. The recent advent of Euro sovereign debt issued in the names of the member states of the Euro area for the Stabilisation Fund offer investors an alternative that provides a higher interest rate than German bunds. Germany is now going to have to pay more for her money as she comes to accept more financial responsibility for the rest of Euroland.

The rate of interest the US has to pay is also rising. This reflects growing concern about the absence of a strong deficit reduction strategy in place to curb future borrowing. UK rates are also on the rise, reminding the government that whilst it has put in place a deficit reduction strategy it is still planning to borrow large sums in the next couple of years and has at some point to end all thoughts of more quantitative easing.

The world economic cycle has moved on from the first flushes of exciting recovery. India and China are well into programmes of seeking to slow their economies by monetary action, whilst their inflation levels remain challenging. Now it looks as if western governments are going to be told by markets that there are limits to how much they can borrow at very low interest rates. As their price of money rises, they will have to make more difficult decisions about how much to spend and borrow, and how to support their banking systems. We do not hold any western government bonds for clients other than very short term instruments in near cash portfolios. Corporate bonds have more protection as they offer much more sensible yields. We would expect the gap between government bond yields and high quality corporate bond yields to narrow, as official short and longer term government interest rates rise.