The dollar in a sandstorm

In the wake of recent requests for debt restructuring an emerging meme asks if some "sovereign bonds" are the new subprime assets.

This argument, most provocatively presented by Gillian Tett, predicates itself on three factors. One, that some government debt has risen to unprecedented levels, with little political credibility to any claims that restraint on expenditure is likely. Two, with the central bank's ‘printing presses' running overtime, a rise in sovereign bond yield (equivalently, decline in prices) is expected as soon as ‘normalcy' returns. Third, banks across the globe have been increasingly loading up on these sovereign debts — a "flight to quality" — where "quality" is synonymous with sovereign treasuries.

Given the interconnectedness of the above mentioned three phenomena, the alarming prospect that some sovereign debt's coupon payments on their bonds will have to increasingly pay for possibilities of default is gaining strength. As economic growth picks up, banks will divert assets into risky investments. Alongside, the present governmental programmes of debt-repurchases and monetisation of toxic assets will come to a standstill. At that juncture, the bond market will begin an active discrimination of sovereign debt.

Fears of inflation induced currency depreciation, rising government deficit induced higher taxes and deep structural macroeconomic misalignments between assets and liabilities are likely to matter more than ever.

Higher levels of deficits lead to the question of who will fund the borrowings? Either via borrowing in the bond markets (which would push rates higher) or through greater monetary profligacy, the consequences for substantive levels of debt are perverse.

This is particularly so, for the long end of the curve. Current estimates by Goldman Sachs indicate that the aggregate gross debt to GDP in the OECD countries is likely to stagger upwards from 91 per cent (in 2010), 132 per cent (in 2020) and 349 per cent (in 2050). On average, in order to stabilise the debt to GDP - an estimated 5.4 per cent of GDP will have to be paid for to keep the current levels indebtedness. The worst four countries with a net debt to GDP greater than 100 per cent are Greece, Ireland, Spain and Japan. UK and US also have to do some serious belt-tightening exercises — around 8.6 per cent and 5.8 per cent of GDP. Most of these expenses emerge from health care and pension costs — especially, in presence of a declining population base.

Going forward, one shouldn't be surprised at all if this meme morphs into a substantiated reality.

However, given these structural constraints in place, one question is where are the foreign exchange rates headed. In the immediate three months — there are two opposing factors at play. On one hand, the long-term budget busting commitments of the developed world continues unabated. While opposing that trend is the suspicious credit quality, nontransparent decision making and institutional ambiguities roil many developing world markets.

The Dubai World issue may result in equities of Japanese and Korean manufacturers (Makita, Hyundai, Chiyoda etc,) getting hit; increased CDS spreads across the board for emerging markets debt and a sobering effects on debt markets in select OECD countries (Greece, Spain) along side with Baltic states. The familiarity of the known seems attractive. Alongside, with the yen's rise to unprecedented levels in more than a decade, the Bank of Japan is widely expected to intervene in the foreign exchange market.

Rising demand

Resultantly, the demand for US Treasuries is likely to continue to increase. This demand will act as a stabilising force for the dollar. Coupled with increase in risk-aversion, the dollar is expected to have a respite from the depreciating spiral. Further, fund managers who had shorted the dollar in anticipation of the long-term decline in dollar against emerging markets are likely to scamper to cover their margin calls and losses due to this flight to dollar. In essence, the "mother of all carry trade" unwinds is likely to reveal itself in the coming months.

For those who believed that volatility in global markets had subsided - the coming weeks will test the courage of their convictions.

- The columnist works for a major European investment bank in New York City. You can follow his tweets at:http://www.twitter.com/ks1729