Bond vigilantes — per James Carville — are intimidating things.
And no more so than in Europe. Rising bond yields in the region have managed to force austerity onto places like Greece, and are currently testing political will in Italy.
So it’s worth considering, as Citigroup’s equity strategy team does in a 24-page note out on Thursday, how bond vigilantes’ interests stack up against those of other investors.
To wit, this set of charts from the bank:
European equity investors don’t want to see an aggressive austerity solution. We believe they would side with the southern European bond markets when it comes to pressurizing for a northern European funded bailout. This is reflected in changing return correlations across the European asset markets. Like most developed world asset markets, Italian bonds and equities were negatively correlated for much of the past decade. But that correlation has turned positive in the EMU financial crisis (Figure 3). This contrasts with Germany where the relationship between German equities and bunds remains resolutely negative (Figure 4). One of the many ironies of the EMU crisis is that the DAX is now more positively correlated with Italian bonds than German bunds.
Current events in Europe should be seen in the context of these shifting alliances. Northern EMU sovereign bond investors want to see more EMU fiscal consolidation. Southern European bond investors want to see some further fiscal consolidation, but they would also like to see bailouts from the north. In the longer term this might take the form of a EMU bonds, but in the shorter term ECB buying will do nicely. Equity investors want to see bailouts. If that suggests inflationary risks and threatens the credit rating of the northern European nations then so be it. That’s the bond market’s problem.
But there’s more to it than that.
Citi reckons, for instance, that eurozone equity vigilantes — the ones keen on bailouts — are intent on forcing the European Central Bank into becoming a more growth-focused ‘stock-friendly’ entity.
In fact, we believe the closer that the equity markets can move the EMU crisis to the core countries then the more likely we are to see an equity-friendly resolution. So this stops being a Greek or Irish problem, or even an Italian problem. It starts to become a French and German problem. This is classic vigilante behaviour. By rapidly escalating a local problem into a systemic problem, we get a favourable resolution from policymakers. And the European banking sector is an obvious mechanism through which to escalate the problem.
Of course, any banking crisis plays out most aggressively in the credit markets. This time is no different. Equity investors need to be careful here. While the ultimate result of further disruption in the European bank credit markets may be some more growth-friendly EMU systemic solution, the price of any bail-out may be brutal dilution of bank equity holders. So bank equity and credit are positively correlated when prices are falling but dilution or nationalization means that share prices are left behind in the post-bail-out rebound.
Because, of course, we shouldn’t forget what was arguably one of the most successful events in bond vigilante history (if you define the group simply as investors seeking to influence policy) …
… that would be their amazing escape from bank losses during the recent financial crisis:
Perhaps the bond vigilantes are now to be found in other areas of the fixed income markets. We could not fail to be impressed by the way that bank bond investors eventually got themselves bailed out in the 2008 financial crisis. When they lost out in the Lehman default, they refused to roll over credit lines to other banks. This liquidity squeeze sent a clear message to policymakers – if you don’t guarantee us then we will bring the whole financial system and global economy to a standstill. As policymakers blinked, bank bonds which had been on the brink of default became AAA overnight. Now that’s proper vigilante behaviour, in our opinion. We can see something similar brewing in the European banking system right now.
Perhaps it’s different this time (not).
Related links:
Feedback loops to give you credit nightmares - FT Alphaville
The distorted European bailout - FT Alphaville
The non-scenic route to the place we’re going anyway – LRB