Business World

Monday 19 March 2018

Dan White: A global bond market rout could delay our bailout exit

As the US Fed prepares to tighten up monetary policy, Irish bonds won't be such an attractive punt

Michael Hasenstab is a money manager at US
investment house Franklin Templeton.
Michael Hasenstab is a money manager at US investment house Franklin Templeton.
Dan White

Dan White

US FEDERAL Reserve chairman Ben Bernanke's comments last week about ending bond purchases are the likely precursor to a tightening of US monetary policy. One of the side-effects of any such tightening could be a sell-off of Irish bonds by overseas investors which would delay our exit from the EU/IMF bailout.

On Wednesday Mr Bernanke spooked the markets when he revealed that the Fed was getting ready to "taper", ie end its bond-buying programme, which is currently running at $85bn (€64.4bn) a month. If the US economic recovery continues at its current pace the Fed will start reducing bond purchases in the autumn before ending them completely by the middle of next year.

The response of the markets to Mr Bernanke's comments was immediate. The Dow lost over 600 points, the equivalent of almost 4 per cent of its value. Even more telling was the collapse in the price of gold, which fell by another $70 to go below $1,300 an ounce for the first time in three years. Gold is now down by more than a third on its 2011 peak of over $1,900.

While I have never been a goldbug, this collapse in the price of gold is telling us something important. As the Fed and the world's other major central banks flooded the markets with cheap liquidity, interest rates collapsed. With conventional financial instruments such as bonds yielding miniscule returns, many investors were unable to resist the siren call of gold.

With Mr Bernanke now indicating that he is getting ready to turn off the tap of cheap money, gold suddenly looks far less attractive. Gold's big disadvantage is that, unlike most other investment categories, it produces no income. Quite the reverse, investors must pay storage costs.

With interest rates at ultra-low levels for the past five years that didn't matter very much. It does now. With Mr Bernanke preparing to end bond purchases US interest rates will rise. This in turn will widen the yield gap between gold and bonds. Hence last week's collapse in gold prices.

So what does all of this mean for us here in Ireland and should we be worried by last week's events?

One of the most remarkable developments on the financial markets of the past two years has been the collapse in Irish government bond yields. Way back in the summer of 2011 those investors brave enough to hold Irish government bonds had to be massively incentivised with the yield, effectively the interest rate, on 10-year bonds standing at a vertiginous 14 per cent. By last week this had dropped to just under 4 per cent.

While Messrs Kenny and Noonan would have us believe that this reduction in Irish bond yields was the result of their stewardship of the Irish economy, this is at best only part of the story. As the yields on American and German bonds shrank to

'Central bank bosses speak in a unique gobbledegook only fully comprehensible to each other'

microscopic levels, American 10-year bonds were yielding less than 2 per cent and German 10-year bonds less than 1.5 per cent earlier this month, bond investors were forced to seek out riskier instruments.

A number of major international bond investors, including Franklin Templeton's Michael Hasenstab, piled into Irish government bonds in the dog days of 2011. At one stage Franklin was estimated to control up to 10 per cent of the total traded stock of Irish government bonds.

Mr Hasentab and the other early investors have been handsomely rewarded for their punt on Irish government bonds. The index of long-term Irish government bonds has doubled in value since July 2011 – bond prices and yields are inversely related so that yields fall as bond prices rise and vice-versa.

But is the great Irish bond rally now at an end and if so, what will the likely implications be?

Although central bank bosses speak in a unique gobbledegook only fully comprehensible to each other, it should now be blindingly obvious that the Fed is preparing to tighten US monetary policy. This is likely to have two main consequences.

Firstly with the flow of cheap central bank funding having been turned off, US interest rates will rise. This in turn will lead to a nasty fall in bond prices as yields go back up to more "normal" levels.

That's very bad news for us here in Ireland. If yields in less risky markets such as the US, and probably in Germany also, rise then why hold Irish bonds? With investors such as Mr Hasenstab sitting on huge profits why not take the money and run?

If, or more likely when this happens the Irish bond market rally of the past two years could very quickly turn into a rout with yields spiking once again. An Irish bond market rout, by raising yields to unaffordable levels once again, would almost certainly put the kibosh on the Government's plans to exit the EU/IMF bailout as scheduled at the end of this year.

There is, however, a possible silver lining. Any tightening of US monetary policy will almost certainly push up the value of the dollar. This will be very good news for Irish-based exporters. Will the benefits of a dearer dollar outweigh the costs of higher bond yields? That's the trillion dollar question

Irish Independent

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