As we recently pointed out in a post titled "Why The Fed Is Trapped: A 1% Increase In Rates Would Result In Up To $2.4 Trillion Of Losses," international monetary policy, which has consistently lowered short-term interest rates in a effort to reflate economies by pushing investors into risk assets, has unwittingly created yet another massive bubble in the long-end of investment-grade sovereign debt. In our previous post, we pointed out that the artificially low short-term rates, while succeeding in creating a massive equity bubble, also served to push yield-hungry investors (skeptical of inflated equity valuations) into the long end of the curve, a fact that will result in substantial losses for those investors when interest rates ultimately revert back to long-term means. Our analysis concluded that a 100bps shock to interest rates could result in market value losses of $2.4 trillion.
In an article posted today, Fitch agreed finding that a reversion of rates to 2011 levels for $37.7 trillion worth of investment-grade sovereign bonds could drive market losses of as much as $3.8 trillion. Fitch noted that unconventional monetary policies in Japan, Europe and the US, together with a surge in investor demand for safe assets, pushed sovereign yields to new lows in 2016, with $11.5 trillion in sovereign securities trading at a negative yield as of July 15. An analysis of yields by maturity pointed out that the long-end of the curve has contracted by ~250bps over the past 5 years.
Fitch also pointed out, as we did, that losses would be greatest for European issuers where yields have contracted the most in a flight to "safety" and duration has been stretched as government issuers take advantage of low rates to stretch out maturity profiles and investors reach for yield.
Sovereign yields for European countries, particularly Italy and Spain, declined significantly since summer 2011 as Eurozone credit risk remained high during that period. If yields in these countries returned to July 2011 levels, the market loss on their debt would be 21% each.
Additionally, the UK's relatively longer maturity stock of debt outstanding would drive total market losses of 19%. For debt with 25 or more remaining years to maturity, investors in European countries would lose 44% in market value on average in this scenario.
At some point in the future we suspect investors are going to wake up and realize that lending money to insolvent "investment-grade" sovereign entities for 30 years at 1.5% probably isn't adequate compensation for the risk being taken. We suspect that realization may only come once it becomes painfully obvious that these countries have amassed trillions in debt that can only be repaid by massive currency devaluations and rampant inflation. Until then, we're sure that everyone will just keep their heads in the sand and continue to play the "greater fool" trade.