MacroScope

Ten-year Greek government bond yields tumbled to their lowest in nearly three years one day after Fitch upgraded the country’s sovereign credit ratings.

Borrowing costs fell to 8.21 percent – the lowest since June 2010, just after Greece received a bailout from the International Monetary Fund and European Union. The difference between 10- and 30-year yields was also at its least negative since that time.

The move comes after Fitch Ratings raised Greece to B-minus from CCC citing a rebalancing of the economy and progress in eliminating its fiscal and current account deficits that have reduced the risk of a euro zone exit.

The fall in borrowing costs suggests investors are pricing out that possibility, as well as the prospect of another debt restructuring, analysts say.

But the move has also coincided with a broad fall in euro zone borrowing costs in April fuelled by abundant central bank cash in the financial system. Thin liquidity in a debt market that was restructured in March 2012 also likely exaggerated the fall, say traders.

Moody’s refrained from cutting Spain’s sovereign rating to junk territory last week, easing immediate fears that Spanish bonds could become vulnerable to forced selling if they fell out of benchmark indices, tracked by bond funds, as a result of the grade reduction.

But that risk still looms large.

Moody’s kept Spain’s rating at Baa3 but assigned it a negative outlook, saying ”the risks to its baseline scenario are high and skewed to the downside.” It said it believed the combination of euro area and European Central Bank support, along with the Spanish government’s own efforts, should allow the government to maintain access to capital markets at reasonable rates.

But should certain factors lead the rating agency “to conclude that the Spanish government had either lost, or was very likely to lose, access to private markets, then Moody’s would most likely implement a downgrade, potentially of multiple notches.”

The battle over the amount and nature of government spending is the focus of the current U.S.presidential campaign and is unlikely to go away even after the November election is well in the rear view mirror.

In such a setting, a paper presented by economist Albert M. Wojnilower at the October 1983 Bald Peak Conference sponsored by the Federal Reserve Bank of Boston, sounds as timely today as it did then. Wojnilower, then chief economist at First Boston, prepared his “Don’t Blame the Deficit” talk as a commentary on “Implications of the Government Deficit for U.S. Capital Formation,” a paper by Benjamin M. Friedman, a professor of political economy at Harvard.

Here is the jist of Wojnilower’s argument, made almost three decades ago when the Ronald Reagan presidency was almost three years old: If the United States is under-investing, the “villain” is not the Federal budget deficit, he said.

The U.S. Treasury Department announced on Wednesday it would begin issuing floating rate notes (FRNs), even if such a new program is at least a year away from implementation. The rationale behind these short-term securities is to give investors protection against the possibility of a sudden spike in interest rates. The Federal Reserve has held overnight rates near zero since late 2008, helping to anchor borrowing costs of all maturities.

But is issuing variable rate securities really a good idea from the taxpayers’ standpoint? Stephen Stanley, chief economist at Pierpoint Securities, thinks not. He believes Treasury officials are getting played by sell- and buy-side investors and their respective vested interests. The Treasury has made the decision in part due to the recommendations of the Treasury Advisory Borrowing Committee (TBAC), made up exclusively of members of the financial industry.

Argues Stanley:

Sell-side participants love it because FRNs represent a new product to trade and one that will be much less liquid and thus may exhibit juicy bid-ask spreads. Buy-side participants love FRNs because they are starving for yield at the short end and FRNs will undoubtedly yield noticeably more than comparable conventional securities.

New York City Mayor Michael Bloomberg slammed the federal government for following the same fiscal path that has cost European governments so dearly, perhaps offering Democratic President Barack Obama and Republican challenger Mitt Romney hints about what policies he would like to see from them to win his endorsement as a moderate independent. Bloomberg’s seal of approval carries added weight because he is a billionaire businessman with close ties to Wall Street, a source of donations as well as a powerful force in the economy.

I think it is clear that we have a deficit problem that is going to hurt this country dramatically and unless we do something about it is a cloud on the horizon. It doesn’t mean America is going to go to zero… But I think if you take a look at Europe and other places and it shows you when you live above your means –  It’s different than the city, the deficits we project are aspirational deficits, in the end we balance our budgets, the federal government does not.

The city by law must close any deficits. In contrast, the U.S. government can borrow to fund its operations – and at very low rates in recent years.

The governor of the Bank of Japan, Masaaki Shirakawa, says he is confounded by the still very low level of Japanese government bond yields given the country’s elevated debt to GDP ratio of over 200 percent. Speaking on an IMF panel over the weekend, he offered a rather unintuitive explanation for the phenomenon:

It seems difficult to explain the case of Japan in light of conventional wisdom. One frequently offered explanation is that the ample domestic savings in Japan have absorbed the issuance of JGBs and the share of JGBs held by foreign investors is very small. But a more fundamental explanation is that the stability in the current bond yields reflects market participants’ expectations that fiscal soundness will be restored through structural reforms imposed in the economic and fiscal areas.

Most economists think Japanese yields are low because of continued expectations for deflation and weak economic growth. But for Shirakawa, it seems, it is public confidence in future fiscal restraint that is keeping bond yields low. Except he then contradicts this point by saying weak confidence in future fiscal reforms is also simultaneously undermining consumer spending:

There’s no other way. In order for Europe to hold together as a monetary union it must be able to issue a currency region-wide bond. That’s according to Christopher Sims, Nobel-prize winning economist and Princeton University professor, speaking on a panel at the IMF over the weekend:

My view is that the only way to preserve the usual manner of operation of monetary policy in Europe, and the usual operation of financial institutions is to deliver on the Eurobond, and not after years but soon. A Eurobond that could be used as the main instrument of monetary policy in Europe would go a long way to stabilizing the financial system.

This explains why Europe is in trouble while other industrialized nations that also face high debt levels are not seeing anywhere near the same market pressures, Sims said:

So the debt crisis is back (did it ever really go away?) but it’s not yet anything like as acute as it was late last year.

Spain is coming under real market pressure, and dragging Italy with it to an extent, but there are good reasons to think it won’t fall over; banks well funded for now and the government’s savvy move to take advantage of benign early year conditions to shift almost half its 2012 debt issuance in three months.

Madrid faces another key test with a Thursday bond auction. Two weeks ago, it suffered its first wobbly debt sale for some months. The turning point is pretty clear – Prime Minister Mariano Rajoy’s decision to rip up Spain’s agreed deficit target for 2012 without consulting his partners. Since then, Spanish borrowing costs have soared though given the amount of debt Madrid has already shifted, that might not be as damaging as it was.

In downgrading the debt to A2, Moody’s ensured that Greek (and other) banks will still be able to swap Greek bonds for cheap funding from the European Central Bank, assuming that nothing has changed by this time next year when the ECB will only accept bonds rated A-/A3 or above as collateral by at least one agency.

Both Standard & Poor’s and Fitch have cut Greek bonds to BBB-plus this month, meaning if Moody’s cuts Greece to an equivalent level, Greek banks are likely to face difficulties in getting access to liquidity as analysts estimate more than half the collateral they have submitted at the central bank is in government bonds.

Yet Moody’s explained the decision as partly due to its expectation that the ECB will keep accepting Greek debt as collateral, a decision which hinges on Moody’s itself keeping Greece’s rating above the watermark. 

Inflation may not be at the forefront of worries about economy for now, but it’s certainly in the back of many investors’ minds. Not that anyone thinks price increases will be reinforced by the labor market, as per the old “wage-push” theory. A new report from the International Labor Organization showed that wage growth continued to decline around the world in 2008, falling to 1.4 percent last year from 4.3 percent in 2007. The UN group also suggested things have gotten worse this year.

The picture on wages is likely to get worse in 2009 – despite the beginning of a possible economic recovery.   Compared to the annual average of 2008, the real wages in the first quarter of 2009 fell in more than half of the 35 countries for which recent data is available.   The downward trend in wages raises some questions about the extent to which the consumption of workers and their families will be able to sustain aggregate demand for economic production once the effects of government rescue packages peter out.

This trend has not, however, succeeded in calming those spooked by unprecedented monetary and fiscal stimulus from governments and central banks around the world. Indeed, inflation-hedging is creating market niches all of its own. The Treasury, for instance, is expected to bring back 30-year Treasury Inflation Protected Securities, or TIPS, as part of its quarterly refunding announcement on Wednesday. Gorge Goncalves at Cantor Fitzgerald notes: