Bonds: a Crisis Risk Indicator?

As a risk professional you've learned to classify an increase in bond's interest volatility (or standard deviation) as an indicator that bonds have become more risky. Right you are....

Now, with this knowledge, let's take a look at the next chart, presenting the long-term (10Y) interest rate of some of the leading EU member states from January 1993 to April 2014:

This chart clearly shows that :

• Since the introduction of the Euro in 1999, country spreads start declining
• Interest rates converge to the year of the famous (Lehman) crisis in 2008
• After the 2008 crisis, rating agencies wake up and spreads explode again

Let's take a look in more detail, by some log scale zooming......

To find out if the convergence of interest rates really is a kind of early warning crisis indicator, let's add some more EU countries to the chart.

Now the picture becomes clear: A structural decline in bond's standard deviation is not a decline in risk, but more the opposite....

As standard deviation decreases, (crisis) risk increases!

We can check this by looking at the cross-country standard deviation development in time:

These charts, presented on a vertical linear and log scale basis, clearly  illustrate that as soon as the standard deviation hits the 0.2% level, crisis can be expected soon.

Not only is the 0.2% SD-level an early warning indicator for the 2008 crisis that started with the bankruptcy of the Lehman Brothers bank, but it's also an indicator of 'Dot Com' crisis in 2000....

Finally
Meanwhile... as from February 2012, standard deviations are declining  again. Time to worry?

Key questions are:

• when will standard deviation hit the 0.2% floor again? 
• and when it does, will there be another crisis?

Remember lesson number 1 in risk management: Crises are unpredictable!
Nevertheless, once 0.2% SD  turns up: fasten your investment seat bells....

Links/Sources:
- Spreadsheet of charts used in this blog
- EU Interest Rates
- Big Picture Chart

Humor: Merkozy, It's too late

Comparing 5 year exchange rates USD/EUR (decline : 17%) and USD/CNY (decline 21%) clearly shows the negative outlook of the US Dollar.

Both U.S. and Europe, are facing severe debt problems they can not solve with more debt.

Desperate actions
President Obama tries to stimulate economy by creating 1.5 mln new jobs with a $ 450 billion investment (American Job Act).

In Europe president Merkel (Germany) and Sarkozy (France) have joint their strengths and totally different characters into 'one personality', to create not only a strong financial but also economic European union.

This new economic union is necessary to establish a firm grip on the measures that weak financial European countries like, Greece, Italy, Ireland, Spain and Portugal have to take to recover from their debt.

It's too late
Unfortunately there's no support for such an initiative. Unluckily, no Merkozy will be able to prevent Europe from a financial meltdown.

The  only way out seems a European split in relative strong and weak countries.

Make up your mind on the geographic spread of the assets of your company. Get out before it's too late....

Actuarial Proverbs: Will Europe Survive?

According to Eurostat, Europe - especially the Euro (€) 'Coin' Countries that put all their Euro eggs in one basket -  face a difficult time. In a world where money seems to grow on trees, it's hard to take the right measures to prevent Greece from a financial meltdown with unknown consequences.

Questions
Even for actuaries it's hard to understand what's happening and what makes sense or not, It's over our 'actuarial' head....

• Should 'Europe donor countries' support Greece fore more than the '110 billion Euro rescue' in 2010?
  
  
• Is Greece’s 10-year bond rate of 15% an adequate risk premium?
  
  
• Will restructuring Greece's debt solve anything, devaluate the Euro,  or pose other  incalculable risks to the overall Euro zone?

Difficult questions that are hard too answer....


Debt-Deficit Comparison
Let's take an actuarial look at the facts by comparing 2010 Government Debt with Deficit (all in % GDP):

From this chart it's clear that not only Greece is in the danger zone, but also Ireland and the US as well... Moreover, the UK is not free from worries, to put it mildly...

The blind are leading...
Another chart-conclusion might be that the blind are leading the blind'. Relative strong less-weaker countries like Germany and France,  have to carry the financial consequences of cheating and not-performing countries. Above all, we all know: one rotten apple spoils the barrel!!

In fact to save or revive 'Financial Europe' it would take some countries with no debt and a strong positive surplus (= negative deficit) instead of a deficit.

It seems neither sensible nor logical  to restructure another  country's debt if the outlook of the governments debt and deficit of the' helping country' is (slightly less) negative as well. But as we know: only fools rush in where angels fear to tread.

Trying to help other countries that fail to restructure themselves is like banging your head against a brick wall...  No risk premium on government bonds can compensate that...

Countries with a strong relative debt and a deficit should restructure their own country and financial situation at once, before asking ore receiving any outside help.

Growth: The Solution?
Some argue that debt and deficits are not so bad as long as countries are growing. Let's dive into this argument with the next chart (data source: Eurostat):

Indeed, from this 'Growth-Believe' we can now understand why (only) Greece is seen as such a major problem.

From this chart it's also clear that if Ireland and Spain are not going to grow one way or the other, they will become the next big problem. These countries have to take the bull by its horns, before it's too late.

It's throwing caution to the wind when 'debt and deficit countries' with a positive 'Real GDP Growth Rate' try to save sicker country-brothers by lending them money.

Moreover, it's lending money you don't really possess or own, it's like robbing Peter (yourself) to pay Paul....

Combining the two Eurostat charts it becomes clear that that not all 'Garlic Countries' (Mediterranean countries:Greece, Spain, Portugal, Italy) can be lumped together.

Greece is indeed the greatest risk , secondly a non-garlic country: Ireland...
Spain, Portugal and Italy are relatively at arm’s length and could perhaps keep their head above water if they take the right measures in time.

U.S.' Fiscal Gap

Finally, don't forget about the U.S., as the U.S. Real GDP Growth Rate is already declining to 2.3% in Q1 2011.

According to Boston University economist Kotlikoff, the U.S. is broke.  Kotlikoff doesn’t trust government accounting. He uses “Fiscal Gap,” not the accumulation of deficits, to define public debt. This "Fiscal Gap" is the difference between a government’s projected revenue  and its projected spending .

By this measure, the U.S. government debt is $200-trillion – 840 percent of current GDP. 

Conclusions

From all this it's clear Europe is stuck between a rock and a hard place...
Although ECB President Mr. Trichet thinks different, it looks like €-Europe has to choose between two blind goats (Irish saying):

(1) A complete Financial Europe Meltdown in case of endless financing default countries like Greece or

(2) Letting individual default countries go bankrupt, with unsure (systemic) consequences for local banks and other financial institutions that financed or invested in default countries.

How to decide? Guideline:  Of two evils, always choose the less....
As option (1) is clearly putting the cart before the horse, and surely leads to a meltdown, only option 2 is left: QUIT!

Sources and related links:
- Spreadsheet: Used Data, Tables for this blog (xls)
- US Real GDP Growth Rate
- Government Debt and Optimal Monetary and Fiscal Policy (2010)
- English proverbs and sayings (!)
- English deficit (including time table)
- Shadowstats (for the real stats!)
- The U.S. is broke?
- Eurostat: Euro area government deficit at 6.0% GDP (2011) 
- BILD: Interview with Jean-Claude Trichet, President ECB, 15 January 2011