Tel. +44 (0)20 7287 4414
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The Bruges Group spearheaded the intellectual battle to win a vote to leave the European Union and, above all, against the emergence of a centralised EU state.
The Bruges Group spearheaded the intellectual battle to win a vote to leave the European Union and, above all, against the emergence of a centralised EU state.

Bruges Group Blog

Spearheading the intellectual battle against the EU. And for new thinking in international affairs.

Dragi doesn’t understand how the bond markets are dangerous


Would you like to lend to the German government and get paid a grand total of 0.43% a year for 10 years?

Or how about lending to the French government and getting 0.73% or to the Spanish government at 1.35%?

An annual yield of 1.35% a year, lending to Spain and you are invested for 10 years. Doesn't sound very good, does it? You won't get rich at 1.35%.

"JOHN BULL can stand many things but he cannot stand two percent." That aphorism, quoted by Walter Bagehot, a 19th-century editor of The Economist, expressed savers' traditional distaste for very low interest rates.

Who would want to buy bonds at such low rates? Why are the yields so low?And why is it that American 10 year government Treasury bonds yields 2.95%, nearly seven times more than the equivalent German bond? Is America really seven times more risky than Germany?

It's pretty obvious, even to a lay-person, that something is wrong. How can Spanish government bonds yield half that of America's, when the American economy is booming and the Spanish economy is at best, stable, and, at worst, just being propped up by low interest rates? Many banks in Spain and Italy are pretty much technically insolvent, as is Deutsche Bank. And there has been a slow drip feed of bankruptcies, the last big one being Banco Populaire that got sold for one Euro.

And similarly, whilst the hunt for taxes is on in Europe - and it has started to tax businesses in any way it can - the US is talking about lowering taxes.This also cannot be good for the European economies.

Indeed, by the ECB's (European Central Bank) own criteria, the bank is itself technically insolvent.

'If the ECB were to apply its own rules to the banks in Europe that say bail-in, not bail-out, then by its own supervision rules, the ECB is insolvent and should be shut down.'

So why are yields so low?

The simple answer is that there has been one buyer, one buyer so big it is almost impossible to comprehend: 2.4 trillion euros! 2,400 billion euros-worth of bonds that have been purchased by the ECB under its QE and asset-buying programme.

This has created a massive shortage of government bonds, quite ironic, given all the government borrowing going on.And because many institutions, like pension funds, have to buy a fixed percentage of government bonds, whether they like it or not, for statutory and regulatory reasons, they have to buy, at whatever price the market is.

Some pension funds have followed the 60% equity and 40% bonds rule, but others, most state pensions, made it 80% bonds and 20% equity.

So yields of government bonds in Europe went down and down and down, and prices of bonds went up and up and up. It was a totally artificial market, propped up by one enormous buyer, using printed money.

And now this is going to stop

ECB calls time on €2.4tn bond-buying programme

Euro falls as markets respond to cautious elements in ECB plan to end QE this year

What Dragi does not realize is that now there might be no bid for all the government debt being issued. Yields on European government bonds might rise massively and prices go into free fall.

As this starts to happen, it will turn into a cascade and a lot of buyers will be left holding enormous losses as they all try to find a small exit at the same time.

Indeed, this could not really happen at a worst time as there are already massive stresses being created in Europe, particularly by the Italian election. Just last week, Italian government bond yields rose in the 2 year section from 0.5% to 2.5% in a couple of hours. Yields going up 500% in a couple of hours is unheard of.

Today, Dragi might have unleashed a torrent that will implode the euro and with it, the entire European edifice.

Brexit might actually not matter so much, because in the next few years, there will be nothing to exit from.

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