Sovereign debt sustainability and CDS returns

November 4, 2023

Selling protection through credit default swaps is akin to writing put options on sovereign default. Together with tenuous market liquidity, this explains the negative skew and heavy fat tails of generic CDS (short protection or long credit) returns. Since default risk depends critically on sovereign debt dynamics, point-in-time metrics of general government debt sustainability for given market conditions are plausible trading indicators for sovereign CDS markets and do justice to the non-linearity of returns. There is strong evidence of a negative relation between increases in predicted debt ratios and concurrent returns. There is also evidence of a negative predictive relation between debt ratio changes and subsequent CDS returns. Trading these seems to produce modest but consistent alpha.

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Public finance risk

April 25, 2020

Fiscal expansion was the logical response to the 2020 health and economic crisis. Alas, public deficit and debt ratios had already been historically high before. The IMF estimates that this year’s general government deficit in the developed world will reach 11% of GDP, while the government debt stock will exceed 120% of GDP. Fiscal sustainability relies on low or negative real interest rates. Yet, on smaller and lower-grade countries credit spreads have risen and become more volatile. In the large developed economies, central bank purchases help to absorb the glut of debt issuance but cannot prevent balance sheet deterioration. Concerns over sovereign credit risk or – more realistically – debt monetization are rational. Fiscal risk and related government strategies will likely be key drivers of financial market trends for years to come.

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Unproductive debt

January 4, 2020

Credit and related interest income have historically been viewed as service and related payment for lending productively. However, in a highly collateralized and risk-averse financial system credit may be granted mainly on the basis of collateral value and aim at wealth extraction rather than wealth creation. On the macroeconomic level, this creates unproductive debt, i.e. debt that is not backed by productive investment. This type of debt carries greater systemic default risk. The rapid increase of debt and leverage after the great financial crisis may be an indication of an unproductive debt problem. For the purpose of macro trading, relevant systemic risk indicators should feature intelligent debt-to-GDP ratios and trackers of collateral values.

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How regulatory reform shapes the financial cycle

October 20, 2018

Ambitious regulatory reform has changed the dynamics of the global financial system. Capital ratios of banks have increased significantly, reining in bank credit. Counter-cyclical bank capital rules slow credit expansions by design and yield greater influence to non-banks. Meanwhile, the liquidity coverage ratio has restricted one of the key functions of banks: liquidity transformation. Regulation has also created its own moral hazards. In particular, the preferential treatment of government bonds has boosted their share in bank assets. The neglect of sovereign risk in liquidity regulation constitutes a significant systemic risk as public debt-to-GDP ratios are at or near record highs in many key economies.

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Update on the great public debt issue

May 5, 2018

The latest IMF fiscal monitor is a stark reminder of the public finance risks in the world. Public debt ratios have remained stuck near record highs of 105% of GDP for the developed world and a 3-decade high of 50% for EM countries. If one includes contingent liabilities public debt would average over 200% of GDP in advanced economies and 112% in emerging economies. Deficits remain sizeable in the developed and emerging world, notwithstanding the mature stage of the business cycle. Overall the financial position of governments today is a lot more precarious than during past recoveries, leaving them ill prepared for future adverse shocks. The U.S. is even easing fiscal policy, expanding its deficit and an already high debt ratio. Also, China’s public debt stock is expected to rise rapidly in future years.

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The systemic risk of highly indebted governments

February 10, 2018

The public debt ratio of the developed world has remained stuck at a 200-year record high, even with a mature global expansion and negative real interest rates. This poses a systemic threat to the global financial system for at least three reasons. First, governments’ capacity to stabilize financial and economic cycles is more limited than in past decades, which matters greatly in a highly leveraged world that has grown used to public backstops. Second, many countries have taken recourse to mild forms of “financial repression”, which puts pressure on the financial position of savers and related institutions, such as pension funds.  Third, future political changes in the direction of populist fiscal expansion can easily raise the spectres of old-fashioned inflationary monetization or even forms of debt restructuring.

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The global effects of a U.S. term premium shock

April 22, 2017

Empirical research suggests that shocks to U.S. treasury term premia have had a persistent subsequent impact on term premia in other developed and emerging fixed income markets. Global financial integration and inflation seem to increase the sensitivity of non-U.S. markets. A 200bps rise in the U.S. premium from current compressed levels could boost the term premia in other countries between 50 and 175 basis points. Hence, a U.S. shift towards reflationary policies or greater net supply of long-term treasuries could greatly increase borrowing costs around the world, exposing weaknesses in overleveraged economies and sectors.

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The global debt overhang

October 15, 2016

A new IMF report illustrates that a large share of both advanced and emerging economies struggle with private debt overhangs. Excessive debt is a drag on growth and a risk for financial stability. Low nominal growth has hampered deleveraging and aggravates these dangers. Moreover, high public sector debt has reduced governments’ capacity to support private balance sheets and stabilize economic growth in future crises. Therefore, the lingering debt overhang provides a strong incentive for fiscal and monetary policies to work towards higher nominal GDP growth now.

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The world’s negative term premium

August 20, 2016

The term premium on the “world government bond yield” has turned decisively negative, according to BIS research. Investors have since 2014 accepted a long-term yield below expected short-term rates, rather than charging a premium on duration exposure. The compression and inversion of term premia may have been fueled by a global duration carry trade and seems to be a global phenomenon. It has coincided with increased correlation of long-term yields across developed and emerging markets.

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“Helicopter money”: A practical guide for markets

June 11, 2016

If current non-conventional monetary policies fail to contain deflation risk, some form of debt monetization or “helicopter money” will become a policy option. The barriers are high but not insurmountable in the G3. Policies could range from a simple combination of QE and fiscal expansion to outright central bank funding or debt restructuring. If and when monetization of government debt becomes apparent the consequences for financial markets would be profound: the policy response to deflation risk would no longer drive bond yields lower but higher.

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Macrosynergy is a London based macroeconomic research and technology company whose founders have developed and employed macro quantamental investment strategies in liquid, tradable asset classes, across many markets and for a variety of different factors to generate competitive, uncorrelated investment returns for institutional investors for over eighteen years. Our quantitative-fundamental (quantamental) computing system tracks a broad range of real-time macroeconomic trends in developed and emerging countries, transforming them into macro systematic quantamental investment strategies. In June 2020 Macrosynergy and J.P. Morgan started a collaboration to scale the quantamental system and to popularize tradable economics across financial markets.

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