Nomura's Chart Of The Week: Differentiating Sovereign Credit In 2011

Heading into 2011, assuming there are no major liquidity/insolvency events (and that is a big assumption, considering Europe is out there, somewhere) which will force more countries to come begging to various central banks, and international monetary authorities, and ultimately, the Federal Reserve, the key question is how should one look at rates, particularly on the long-end, opportunities in a world in which suddenly everyone (expect the US of course), is seeing their economies contract courtesy of austerity (which was just voted Webster's word of the year 2010). Demonstrating the continuum when it comes to making credit differentiation conclusions based on fiscal inequality, is Nomura's chart of the week, which provides a convenient tearsheet for the progression from Hong Kong on one end of the fiscal balance shortfall forecast spectrum, and ending with Greece, Ireland and Spain on the other. As Nomura notes: "Heading into 2011, significant fiscal divergence looks like a key theme for markets." This merely goes back to our broader theme from earlier this year, that any real asset upside will have to be made in the FX market, where relative performances are likely underappreciated, as opposed to equities, which are largely shunned by most, and where the only possible trade remains a levered beta play which, as always, takes the escalator up and the elevator down.

From Nomura:

One interesting feature of global bond markets in 2010 is the persistent strong correlation at the longer end of the curve. Through the course of this year, short ends of global bond curves have de-correlated as monetary policies between strong and weak balance-sheet countries have diverged. But for the most part, outside of the euro zone, long-end yields have tended to move in line with each other.

The de-correlation of euro zone long ends is instructive, as it shows that the perception of diverging credit risk can be a key driver of long-end sovereign curves in the post-crisis environment. Heading into 2011, significant fiscal divergence looks like a key theme for markets. The chart above looks at expected levels and changes in fiscal balances as a percent of GDP in 2011. A few points are clear. First, despite suggestions that Spain has not done enough, its fiscal contraction in 2011 will be the biggest in our overall sample. The other main periphery countries are next in line. The UK's austerity measures are also large – among the biggest of a country not experiencing any bond market stress. On the flip side, emerging markets expect to see the smallest fiscal contractions. Indeed, Hong Kong's overheating economy is actually set for a small fiscal boost compared with 2010. In G10, Japan is perhaps the biggest worry – we expect renewed deterioration in the fiscal balance next year from an already high level (even by Japanese standards). The US also expects to see little improvement, especially after the agreed extension of Bush-era tax cuts, along with other fiscally positive measures.

If credit\fiscal differentiation is to be a big theme in 2011, a few trends should be clear. We would look for UK long-end outperformance against some of the G10's more profligate government curves – like Japan and the US. If Europe's periphery can stick to plans (a big if), the longer end of the curves may start getting some relief from investors. And, in those emerging market countries where growth is strong and fiscal policy is loose, look for curves to steepen further.

One thing not openly discussed is just how likely it is that countries like Spain will actually follow through with achieving some/any fiscal balance improvement in light of the requirement to refinance/roll/mature hundreds of billions of debt at rates that not even the most obstinate bulls claims are viable. Although in a world where every data item is merely used to substantiate the thesis that the can may be kicked down the road for another year, expect to see increasingly more avoidance of discussing the actually relevant data.

Comments

[Bam_Man]

My vote for the "Sovereign Credit Black Swan" of 2011 is a JGB implosion, followed almost instantaneously by a collapse of the Yen and a hyperinflation lasting well into 2012.

[fe09rt65]

keep calling it and eventually you will be right

[epsilonphase]

jgb implosion? right... because all the oba-sans and jiji's are going to simulataneously pull out all their savings out the bank and do what?

[huckman]

What's the JGB weighted average cost of capital?

[[e-mail]]

Weighted cost of government debt is 1.4% and it absorbs 25% of government revenues.  A move to 2.8% would look interesting.

[Robslob]

If you are smart enough to ask that question than surely you are smart enough to answer it...and yes, I just called you Shirly....

[irishlink]

Austerity! begets stupidity. check out these "bright ideas"http://www.-sbpost.ie/themarket/state-to-take-a=hit-on-abolished-propert... and this http:/www.sbpost.ie/news/ireland/landlords-angry-over-section23-changes-52534....

[TexDenim]

It is becoming more and more difficult to roll Europe's difficulties over for another year. 2011 may be the year the ECB has to deal with the reality of massive European insolvency, unless of course Uncle Ben steps in and uses US credit to forestall the inevitable for another year or two. Makes me think maybe 2012 is indeed the year the world comes to an end.

[mberry8870]

So my question is what is the US's total share of the debt market not what debt to GDP issues there are. Seems to me if a liquidity issue besets the debtors all at once the issue will be available size of the debt market not the amount of debt supporting profligate  spending --- yet.