Milestones in Bond Insanity

Two events happened this week for the first time: negative yield on 10-year government bonds and 100-year bonds by Mexico denominated in euros.

Please consider Swiss, Mexican Bond Deals Represent Milestones for Debt.

Until Wednesday, no country had ever sold 10-year debt that gives investors a yield of below 0%. And no country had ever issued a 100-year bond denominated in euros.

But in the latest stark sign of how easy the era of easy money has become, Switzerland on Wednesday sold 10-year bonds that investors are actually paying to hold, while Mexico lined up a rare transaction to borrow euros it promised to repay a century from now—at a yield of 4.2%

The two extraordinary milestones reflect Europe’s extraordinary environment.

Reserve prepares to raise interest rates, the European Central Bank is forcefully driving them down. The Swiss National Bank, eager to keep its currency from soaring too far above its eurozone neighbors’, has itself shoved interest rates below zero.

The consequence is a strange collection of monetary phenomena: The ECB has begun charging commercial banks to keep money on deposit. Denmark’s central bank has furiously printed kroner to mitigate a flood of capital into the country. Even Spain, which once looked on the cusp of fiscal collapse, is able to sell short-term Treasury bills that give investors back less principal than they started with.

In January, Switzerland’s central bank, worried about the consequences of buying huge volumes of euros to keep the franc suppressed, scrapped its upper limit on the franc and cut deposit rates to minus 0.75%. Foreign-exchange markets were thrown into turmoil. Given that putting cash on deposit costs money, the very modestly negative yield of the new 10-year bond is marginally attractive. A similar story is playing out in the eurozone, where the ECB has set its deposit rate at minus 0.2% and aggressively bought bonds.

Mexico’s interest in selling the bond at 100 years was partly to extend the maturity of its debt stock, but also to expand its presence in the euro bond market, said Alejandro Díaz de León, head of public credit at the Mexican Finance Ministry. “By placing debt at an exceptionally long maturity, it helps to consolidate Mexico as a widely accepted issuer,” he said.

The sale wrapped up Mexico’s foreign capital-market financing needs for 2015, and comes as the government moves to reduce spending this year and next because of lower oil prices and expectations of tougher financing conditions in the future—particularly when the Fed begins raising interest rates.

Jim Esposito, co-head of global financing at Goldman Sachs, who worked on the deal, said demand was “driven by European money managers” but also saw some U.S. buyers.

Huge Risks

Will the euro even be around in 100 years?

Even if the euro is around in 100 years, what countries will be in it? The value of the euro will vary widely if the answer is peripheral Europe vs. Germany, Austria, etc. Mexico is taking a gamble on this.

Of course, if the peso rises vs. euro, Mexico comes out ahead.

Euros vs. Mexican Pesos

Analyzing the Risk

In April of 2001 one euro bought 7.7 pesos. Today, one euro buys 16.1 pesos. That is a decline of 52%. Had Mexico done this transaction in 2001, it would be 52% in the hole on the currency move alone. And given that yields are lower now, no doubt it would be hugely underwater on interest as well.

Issuing debt or taking on debt in foreign countries is risky business. Just ask all those in Poland, Hungary, or the Czech Republic who took out mortgages in Swiss Francs. Many will lose their homes because debt payments have skyrocketed along with the soaring Swiss Franc.

As recently as 2009, one euro bought 20 Mexican pesos. Looking ahead, is it so hard to believe the Peso will not sink to that level or even a bit further, say to 25. A move to 25 pesos per euro would put Mexico 36% in the hole on currency fluctuations, and it would only collect 4.2% in interest.

I have no particular insight into which way the move will go, at least in a stated timeframe. I am simply highlighting the currency risk. There is interest rate risk as well, but at least that is defined.

Whether this deal works out well and for whom, depends on currency fluctuations.

The big risk is a eurozone breakup. If Germany exits the euro (which I think it should do, but probably won’t), Mexico wins big as the euro would sink vs. the peso. If Greece, Spain, and Portugal leave the eurozone, the euro could easily strengthen by a lot, perhaps after a bit of volatility.

Are 1000-Year Bonds Next?

Given that countries are issuing bonds in foreign currencies for 100 years, why not 1000 years, or perpetual bonds?

After all, no country really ever intends to pay back this debt in the first place. Debt just grows, and grows, and grows.

A currency crisis is on deck, but few see it coming.

Mike “Mish” Shedlock