Whether its Greek bonds or UK housing, the markets are ruled by extreme mispricing.
By Jeremy Warner, Assistant Editor
Published: 10:37PM BST 01 Sep 2010
Here's my holiday resolution; I'm selling the house and piling the proceeds into Greek government bonds.
Only kidding, though the case for doing so is actually more compelling than you might think. UK house prices look likely to fall, or at least stagnate, for some years, while the outlook for Greek debt is in reality much better than generally appreciated: the chances of default, even in the form of an agreed restructuring, are a good deal more limited than the markets seem to imagine.
Recent data on the UK housing market has confirmed that the mini-recovery in prices that occurred in response to zero interest rates - and thanks to a weak pound, a big revival in overseas buying - is probably over. From here on in, underlying economic fundamentals are likely to reassert themselves – stubbornly high joblessness, disposable incomes depressed by higher taxes and saving, and scarce mortgage finance.
After the excesses of the last boom, the Financial Services Authority seems determined to push ahead with loan-to-value controls on mortgage lending, but even accepting that this is unambiguously such a great idea (in point of fact it will only further freeze first time buyers out of the market), it looks far from necessary; the banks are doing it of their own accord.
In any case, it's hard to remain bullish about property prices. Greek government bonds, on the other hand, are once more, and not withstanding the joint EU and IMF bailout, trading at levels that discount an extreme act of default. Over the summer holidays, spreads have widened back to the crisis levels that ruled earlier this year: the yield on ten year Greek bonds is again above 11pc, against little more than 2pc for equivalent German bunds. It scarcely needs saying that if Greece doesn't default, its bonds represent outstanding value.
Yet to judge by a convincingly argued analysis from the International Monetary Fund published on Wednesday night, the chances of sovereign debt default in advanced economies, even for countries as fiscally challenged as Greece and Ireland, are remote.
The IMF's argument essentially comes down to the finding that the costs of default would be considerably greater, even when the haircut is agreed by creditors, than a pre-emptive fiscal consolidation, however painful the consolidation might be. In these circumstances, default becomes, to use the IMF's words, "unnecessary, undesirable and unlikely".
Now plainly, the fact that something is "undesirable" and carries greater long term costs than the alternatives, is not sufficient to prevent it from happening. Even so, it is apparently the case that countries rarely, if ever, strategically decide to default in order to relieve their debt burden. Economies are instead forced into default by recurrent refinancing crises.
There is a long case history of this occurring in emerging markets, where the cost of borrowing is invariably high, but there is no reason it should happen in advanced economies, including Greece. Although marginal interest rates are now high for Greece and some other European peripheral economies, average interest rates on the stock of debt are still relatively low, which gives ample time for convincing fiscal adjustment.
Default may temporarily reduce the overall debt burden, and its costs, but it doesn't deal with the underlying problem of unsustainable deficits, and in nearly all cases results in borrowing markets becoming closed to the defaulting nation for a prolonged period of time. Painful, but manageable fiscal consolidation is overnight transformed into enforced penury.
On this analysis, then, Greece will not default, and nor will any other advanced economy. Yet there is one rather important scenario that is missing from the IMF's analysis – the possibility of a double-dip recession, disinflation, deflation or even outright depression.
In circumstances where the economy continues to contract, the real burden of debt relative to GDP will rise almost regardless of what governments do to cut spending and raise taxes. The IMF's sanguine analysis ignores this very real possibility.
Markets, of course, are not so careless; to the contrary, they seem ever more intent on making this deflationary nightmare actually happen. Wednesday's surge in share prices may pressage a return to a more common sense view, but that's not what bond prices are telling us. The reverse image of Greece's 11pc-plus 10 year bond yield is, bizarrely, record low, sub 3pc long bond yields across the entire G7 bar Italy.
Just four months ago, we were all worrying ourselves sick that other advanced economies including the UK would soon succumb to the Greek disease. The Governor of the Bank of England, no less, warned that without swifter deficit reduction there was a real risk of sharply higher interest rates and fiscal meltdown. Since then we've had a new government, the emergency Budget, and a deficit reduction plan in keeping with the Governor's demands. But that's not why 10-year gilts are trading at sub 3pc yields.
Rather it is to do with fears of deflation, another bout of severe risk aversion and a consequent flight to safe haven assets. It seems odd that investors, who just a few months back were fixating on sovereign debt risk should choose to shelter their money in the very assets that are the cause of the latest leg in the crisis, but everything is relative, and if all other assets are thought unsafe, there's only sovereign debt and gold left.
To me, the consequent mis-pricing of G7 debt looks almost as extreme as that on Greek bonds, only the other way around. Only a fool would altogether discount the possibility of a deflationary outcome.
But personally, I'm not yet willing to accept that this is where we will end up, even though Ben Bernanke's bald assertion last week that deflation remained unlikely was worryingly short of hard evidence.
Markets frequently get it completely wrong, and both on the upside and the downside have a tendency to extreme overshooting. That's what I suspect is happening here. Of course, there are good structural reasons for the current love affair with advanced economy sovereign debt. In ageing populations, money is naturally drawn to such apparently risk free, near cash assets. But do you really think that 10-year gilts offering what at present is a negative real rate of interest (remember, CPI inflation is still at 3.1pc) represent a sound investment? In Britain, with its long history of inflation? I don't buy it.
http://www.telegraph.co.uk/finance/comm ... icing.html
