FT Alphaville " On the transfer of risk and the mystery of low yields It is impossible for all investors to be invested in safe assets all at the same time. That's because risk can never truly be eliminated. It can only be transferred or managed. The more people pour into "safe assets" at the expense of "risky assets," the more they transfer risk into the original "safe asset." This is the oxymoron that currently applies to the bond markets. The act of chasing safe assets compromises the very same assets. Governments have two ways to respond to this situation. They can allow the market to forsake risky assets altogether and thus start to compromise the safety of the country's supposedly risk-free assets. Or, they can purchase the risky assets on the market's behalf. Take the risk away from the market, while providing an equal proportion of new "safe assets" to replace the risky assets which are now gone. In this way investors don't crowd each other out when fighting over existing safe assets, and don't destroy principal for the chance to protect their wealth. This is largely what happened in Europe, but with one very important caveat. The eurozone had a fragmented bond market which was serviced by a single monetary authority. As a result, as individual sovereigns picked up more and more risk (via contingent liabilities and such), investors became incentivised to pour money into the next safest alternative fragment and forgo unsafe fragments altogether. (We think the encumbrance of periphery safe assets such as Greek bonds in the original 12-month LTRO probably encouraged this behaviour too. After all, why fight over access to a limited supply of Greek bonds when you can easily shift into the next safest fragment without a fight.) For the sake of brevity let's say the safest fragment was represented by Germany and the unsafest fragments were represented by the periphery. This meant that the unsafe fragments had no choice but to start taking what were previously considered "safe assets" (government bonds) off the table as well, because nobody was willing to hold them, contrary to what might usually have been expected. Instead you arrived at the same situation as above, but with the crucial difference that all periphery assets were now deemed unsafe while all Germany government bonds were deemed extra safe. Not enough safe debt The problem we have now is that there aren't enough German bonds to compensate for all the securities that have been taken off market by the ECB system (the risk that the ECB took on on behalf of the market). This is what is driving yields lower. Thus, unless the German Treasury provides a compensatory amount of fresh safe assets, German bonds will continue to be crowded out and in so doing continue to suffer from voluntary principal destruction. We don't think there is a debt-to-GDP constraint to Germany issuing more debt, especially while German yields are so low. Of course, if a single Eurozone body was to provide an alternative safe asset to the market to compensate for this overflow, it could very well stabilise the situation in Germany and stop capital fleeing the eurozone outright. It would not, however, solve the periphery's problem. That problem can only be resolved by investors seeking out risk assets again, something which will be determined by market psychology and expectation. Until investors believe risky assets can pay out - without compromising principal - the only market left for periphery bonds will be inside the ECB's balance sheet. The low-yield Treasury mystery On a related note, we were struck by the following post from Cullen Roche at Pragmatic Capitalism on Thursday attempting to debunk the internet scaremongering that's going on regarding low Treasury yield. Others have attempted to quell these conspiracy theories too. We commend their efforts. However, we'd like to add our two cents worth. First, we find it remarkable that anyone should be baffled by why high prices for US Treasuries exist at the current time, even despite maximum supply. Maximum supply means nothing in its own right. Supply must be taken in the context of global safe assets, which are diminishing, and in the context of assets generally. Risky assets included. As and when risky assets become toxic no-go areas, the global supply of assets is compromised. Wealth is temporarily destroyed. Risk is transferred into safe assets. This has been well explained by Manmohan Singh and Peter Stella in an IMF working paper. If governments or central banks intervene to take the risky assets out of the market (risky assets which might still perform to some degree), they help to contain the transfer of risk. However, unless the assets they take out of the market are matched by an equal or increasing supply of safe assets - something which is being restricted by the debt ceiling controversy - the crowding out of safe assets leads to ever lower yields. This is especially the case if the government begins removing safe assets from the market as part of quantitative easing as well, replacing them with base money much of which then has nowhere to go. This is the cost of liquidity. As we have always said - absent pure helicopter money drops - QE is nothing more than an asset switch. By removing safe assets from the market and replacing them with base money, the central bank is hoping that investors will regain their risk appetite when faced with poor yields in Treasuries. But since that's not happening - because it requires a mental shift linked to expectations - it's resulting in ever lower yields instead. It's as simple as that. There is no conspiracy. Related links: Who's Propping Up the U.S. Treasury Market? - The Street Why Are Treasury Yields so Low? - Pragmatic Capitalism Central bank existential crisis confirmed - FT Alphaville Goldman Sachs on fewer "safe assets" - FT Alphaville This entry was posted by Izabella Kaminska on Friday, June 29th, 2012 at 11:40 and is filed under Capital markets. Tagged with bunds, ecb, Treasuries.