Has the UK finally lost its safe haven status?

Claus had an interesting post just now on the meaning of the Moody’s downgrade of UK sovereign debt. He sees this more as a renewed opportunity to focus on the meaning of safe haven status than as any market-moving signal since Moody’s is late to the game. Claus also gives a stab at defining what a safe haven status entails. Here’s the list:

1. Large, stable and structural external surpluses
2. High net savings, strong net foreign asset position
3. Positive government balances, stable and low domestic interest rate environment
4. Non-volatile real return on base rate linked products
5. Open capital account (ease of getting money in and out, but because of the strong current account currency volatility would likely be relatively low)
6. Deep and liquid financial markets.

Claus writes in conclusion that:

I am sure I have forgotten something, but it obviously occurs to me that such an economy does not exist today. It is better then to recognize this than trying to lump all kinds of different economies together as safe havens just because they offer positive nominal yield; because eventually even the most solid perceived safe haven may ultimately fall. Just look at the UK.

Agreed. Such an economy does not exist and there is no use in investors lumping all kinds of different economies together in their quest to find safe assets somewhere in the global economy. Certainly, this economic crisis has reduced the number of safe assets on offer and that makes it trickier for investors.

My take on safe havens is different than Claus’,  however. Let me run through my thinking here. Think back to my December 2011 post on “Bond vigilantes and the currency relief valve“. The point I tried to get across then is that domestic investors should consider liabilities of any sovereign with substantially all of its liabilities in a currency it can create as the risk-free asset class. The sovereign cannot involuntarily default on those liabilities since it can always create more. The only question in creating more liabilities are whether that creation causes inflation and currency depreciation.

For domestic investors, then, government liabilities in sovereign currency areas will always represent the safe haven asset class. There is no currency risk or liquidity risk. There is no re-investment risk from bond put options. And the interest rate risk is mitigated by a politically-aligned central bank, something we are now seeing more and more of, with Japan in the pole position here. Read more on the move to a consolidated fiscal and monetary policy for an expanded discussion. Most importantly, there is no default risk – except what I call the Equador risk factor – which goes to willingness rather than ability to pay. Bottom line: in a time of crisis, for domestic investors, no asset class is safer than their sovereign currency government’s securities.

The euro zone is different. As I laid out when the European sovereign debt crisis was catching Italy for the first time in July 2011, Italy and all the other euro zone governments are currency users that must ‘get’ euros. They cannot create them. This makes them vulnerable to default. And the institutional arrangement doesn’t permit the ECB to be politically aligned with the individual sovereign governments to promote so-called monetisation. While the OMT program is a good end run around this precept, it comes with austerity strings attached. On the whole then, the euro institutional arrangements make it harder for euro zone governments to achieve safe haven status.

Germany has the safe haven status in the euro zone. There is no currency risk or liquidity risk for domestic investors. There is no re-investment risk. And while there is some interest rate risk, all other bonds in the euro zone share that risk. Most importantly, however, the euro zone would have to collapse entirely for Germany to default. And even then, you would need some pretty specific and highly unlikely circumstances for that to occur. I look at the spreads in the euro zone core as representing default risk more than an assessment of the macro fundamentals of the individual government bond issuers. After all, Germany’s government fundamentals are worse than Finland’s or the Netherlands. Right now Finland trades 19 basis points wide of Bunds and the Netherlands trades 30 points wide of Bunds. Finland fulfills all of the Maastricht Treaty requirements where Germany has often been in breach and its government debt to GDP, while converging to the 60% Maastricht hurdle, is still well above it at over 80%. My point here is that, yet again, we see that safe haven status depends critically on default risk. However, since the eurozone is a manufactured currency area there is so-called redenomination risk, which despite the ECB’s efforts, have not been entirely eliminated.

Now, I have been talking abut domestic investors here whereas Claus was talking more about foreign and domestic investors. But I think it’s key to get the domestic investor safe haven criteria down first. Extending this to foreign investors is really mostly a case of currency and interest rate risk. Niels Jensen put it well earlier this month:

Now, let’s remind ourselves of a couple of general misconceptions. Firstly, the notion that foreigners can pull out of, say, UK assets just because they lose faith in UK economic policy is fundamentally flawed. National income accounting principles assure that net foreign capital inflows into the UK will always equal the UK current account deficit (the flowidentity). For precisely the same reason, the total stock of UK assets held by foreigners must equal the sum of all past deficits (the stock identity). These two principles are accounting identities and will always be valid, whatever country you look at. So long as a country runs a current account deficit, foreigners will accumulate claims on it whether they wish to do so or not. Likewise, countries that run a surplus will accumulate claims identical to the size of the surplus.

The second mistake is the failure to recognise that when foreigners become disenchanted with Her Majesty’s Government, they can be ‘appeased’ either through higher bond yields or through reduced currency risk. In plain English, the bond market is not the only adjustment mechanism. Whilst we all sit and wait for bond prices to fall out of bed, the currency may in fact take the brunt of the adjustment.

Hence the question investors should really be asking themselves is under what circumstances will bond yields rise and under what circumstances will the currency weaken? This has little to do with currency wars and much more to do with an economic theory developed by James Tobin (amongst others) back in the 1970s and 1980s. Let’s have a crack at it.

How the theory works

The first factor to consider is asset preferences. Let’s assume that foreign investors have become disenchanted with UK bond yields which they consider to be unattractively low. As a result, they wish to sell their UK gilts and invest the proceeds in UK equities instead (remember, they cannot ‘exit’ UK assets altogether due to the accounting identities discussed above). Assuming domestic investors’ asset preferences remain unchanged, virtually all the adjustment will take place in the currency markets. The logic is straightforward. Since domestic investors’ asset preferences are unchanged, the moment they observe falling bond prices and rising equity prices, they will take advantage of those price moves and reinstate what they consider to be the equilibrium between bond prices and equity prices. As a result, under the circumstances described above, the currency bears the brunt of any adjustment necessary to appease foreign investors. By the same token, should domestic and foreign investors become disenchanted at the same time, bond yields will rise whereas the currency will only be modestly affected.

Precisely the same argument can be put forward as far as inflation expectations are concerned. Should these change simultaneously for domestic and foreign investors, bond yields will rise. Should foreign investors change their inflation expectations for the worse whilst domestic investors remain more sanguine, the currency will take most if not all of the impact.

The third dynamic to consider is trade and hence the current account deficit. Assume for example that foreign investors’ asset preferences have begun to affect the exchange rate. This may in turn have an effect on the trade deficit over time, as the weakening currency is likely to favourably impact the level of competitiveness. Then again, the more the trade deficit improves as a result of the weakening currency, the more bond yields may rise over time due to the law of supply and demand of funds. Why? Because the improving trade deficit leaves fewer pounds in the hands of foreigners to be invested in UK assets.

Finally, consider the savings rate. It may or may not change as a result of the above but let’s assume for argument’s sake that total domestic savings increase by an amount equal to the improvement in the trade deficit. If that were to happen, the supply/demand argument in the previous paragraph falls away, as the falling demand from foreign investors due to the improving trade deficit will be offset by increased demand from domestic investors due to the growth in savings. In this case, bond yields will be unaffected.

Again, the currency is the release valve.

As a foreign investor, especially when thinking of currency and interest rate risk, it is real interest rates that matter. And in today’s world of low to near zero nominal rates, everywhere in the largest currency areas, it is the inflation rate that matters most. Japan’s currency appreciated during this crisis because its real interest rates were higher than everyone else’s. Everyone had near zero rates and Japan’s inflation rate was the lowest. Now that fiscal and monetary policy are aligned as they always could and will be in times of economic crisis, inflation expectations are rising in Japan. And with the currency as the principal release valve, foreigners are shunning Yen as the carry trade unwinds.

In sum, for domestic investors, the safe haven asset class are government liabilities if the government has substantially all liabilities in the currency it creates. In the euro zone, where governments are not sovereign, the ECB has become more aligned with individual governments in order to reduce ‘re-denomination risk’. Some residual red-denomination risk and a lot of default risk still remains as these governments are still currency users. Nonetheless, Germany retains safe haven status within the euro zone  because of the lack of default risk. For foreign investors, like domestic investors, you want to protect against default risk by investing in a currency area’s risk-free asset class but you also want to mitigate currency risk. That’s what safe haven risk is all about. The other stuff is irrelevant. The UK remains a safe haven domestically. But inflation expectations have increased and that means currency risk now mitigates Gilts as a safe haven internationally.