Weekly Market Commentary. June 8, 2015.

The Markets

If it looks like a bond, and it acts like a bond…oh…that’s the problem. Government bonds aren’t acting the way investors expect.

Last week, 10-year U.S. Treasuries – which, typically, are thought to be safe and stable investments – suffered the biggest one-week sell off since June 2013, according to The Wall Street Journal. Treasuries finished the week yielding 2.4 percent, a gain of 0.3 percent. In the world of stodgy, backed-by-the-full-faith-and-credit-of-the-U.S.-government-bonds, that’s a big change.

The performance of U.S. bonds paired with that of German government bonds. BloombergBusiness reported 10-year Bunds delivered their worst weekly performance since 1998. On Friday, the German benchmark bond settled at 0.8 percent after rising to almost 1 percent on Thursday. In late April, the yield on Bunds was at an all-time low of 0.049 percent.

So, what’s going on? Why are bond values fluctuating so much? Barron’s said the problem is a lack of liquidity in fixed-income markets:

“The global financial system is awash in liquidity, created by central banks as they have driven short-term interest rates to zero (or even below) and expanded their balance sheets by the equivalent of trillions of dollars. And so the world is swimming in cheap money. At the same time, liquidity is said to be at a low ebb in the financial markets, especially for bonds… As a result, transactions that once didn’t cause prices to budge now send them lurching from trade to trade… And the advice from central bankers on both sides of the Atlantic about this new volatility? Get used to it.”

One reason for the lack of liquidity is the relative scarcity of market makers, reported Barron’s. In the past, banks made markets – buying and selling for their own accounts – which created liquidity, but new regulations have curtailed those activities.

Looking beyond bond market illiquidity, there was economic good news in the United States: employment numbers improved. However, investors worried that could push the Federal Reserve toward a rate increase sooner rather than later, and U.S. stock markets finished flat to lower for the week.

S&P 500, Dow Jones Global ex-US, Gold, Bloomberg Commodity Index returns exclude reinvested dividends (gold does not pay a dividend) and the three-, five-, and 10-year returns are annualized; the DJ Equity All REIT Total Return Index does include reinvested dividends and the three-, five-, and 10-year returns are annualized; and the 10-year Treasury Note is simply the yield at the close of the day on each of the historical time periods.

Sources: Yahoo! Finance, Barron’s, djindexes.com, London Bullion Market Association.

Past performance is no guarantee of future results. Indices are unmanaged and cannot be invested into directly. N/A means not applicable.

When a government has a lot of debt, is it better to implement an austerity plan and pay the debt down? Or, take advantage of low interest rates and invest in the country?

Since the financial crisis, countries around the world have racked up a lot of debt through stimulus programs, financial bailouts, and other monetary and fiscal rescue efforts. When Should Public Debt Be Reduced?, a new paper published by the International Monetary Fund (IMF), reported advanced economies currently have some of the highest debt ratios of the past 40 years.

So, should they be paying off their debts? It all depends on how much ‘fiscal space’ your country has, according to the IMF. The Economist explained it like this:

“This concept [fiscal space] refers to the distance between a government’s debt-to-Gross Domestic Product ratio and an “upper limit”, calculated by Moody’s, a ratings agency, beyond which action would have to be taken to avoid default. Based on this measure, countries can be grouped into categories depending on how far their debt is from their upper threshold… It is a decent measure of how vulnerable a government’s finances are to a shock.”

The IMF report concluded countries already at the upper limit – like Japan, Italy, Greece, and Cyprus – are out of luck. They must take action to reduce debt levels. However, for countries that have fiscal space, there may be merit to the idea of “simply living with (relatively) high debt and allowing debt ratios to decline organically through output growth.”

In other words, if the country’s economy grows faster than its debt, the debt will become a smaller percentage of GDP, resolving the debt issue gradually over time. Given enough time and economic growth, the problem could resolve itself.

The IMF cautioned these conclusions do not constitute policy advice. The paper was intended to fuel debate about the proper course of action for rich, but indebted, countries.

You have brains in your head. You have feet in your shoes. You can steer yourself in any direction you choose. You’re on your own, and you know what you know. And you are the guy who’ll decide where to go.
— Dr. Seuss, American writer and cartoonist

http://www.wsj.com/articles/u-s-government-bonds-sell-off-after-healthy-jobs-report-1433508534 (or go to http://peakclassic.peakadvisoralliance.com/app/webroot/custom/editor/06-08-15_WSJ-US_Government_Bonds_Suffer_Biggest_Week_Selloff-Footnote_1.pdf)
http://online.barrons.com/articles/a-liquidity-time-bomb-in-the-bond-market-1433555105?mod=BOL_hp_we_columns (or go to http://peakclassic.peakadvisoralliance.com/app/webroot/custom/editor/06-08-15_Barrons-A_Liquidity_Time_Bomb_in_the_Bond_Market-Footnote_4.pdf)
http://online.barrons.com/mdc/public/page/9_3063-economicCalendar.html?mod=BOL_Nav_MAR_hpp (Click on U.S. & Intl Recaps, “A walk on the wide side,” then scroll down to Global Stock Market Recap chart) (or go to http://peakclassic.peakadvisoralliance.com/app/webroot/custom/editor/06-08-15_Barrons-Global_Stock_Market_Recap-Footnote_5.pdf)
http://www.economist.com/blogs/freeexchange/2015/06/public-debt (or go to http://peakclassic.peakadvisoralliance.com/app/webroot/custom/editor/06-08-15_TheEconomist-How_Much_is_Too_Much-Footnote_7.pdf)