A bleak roadmap regarding QE/Sovereign Debt/Bond Market/USD

Overall roadmap for the period 2008–2032

My thought-process starts with QE, which was started as a response to the 2008 financial panic. Now that there have been zero to negative real interest rates on government bonds as well as savings for a few years, I found a potentially troubling connection between pension funds and government bonds. Pension funds usually own some government bonds since they traditionally have had a decent yield, are “safe” (lower risk of default), and in many cases are actually forced by law to hold a substantial percentage.

Given these very low interest rates in the last 8 years, this has affected pension funds tremendously since they need the yield to be able to pay the pensions. See the following news articles and opinion pieces for supporting evidence, especially in regards to Europe:

Negative Rates Drive Major Changes at European Pension Funds
Who Wants To Buy Europe’s Negative Interest Bonds?
Negative interest rates ‘poison’ German pension funds

How ultralow interest rates could devastate pension funds, insurers

Now after realizing this, I thought that there would be more or less three options left:

1. Governments are forced to cut pensions and benefits
2. Pension funds are forced to diversify into other riskier financial assets
3. Pension funds force the QE + zero/negative interest rate policy to end

Concerning point 1, I would wager that it’s actually very politically difficult if not impossible to cut these benefits when most of the hurt economies by the crisis (in particular Europe) have not recovered. Doing so would lead to less spending, an even greater tendency to save money, lower investments, and general slow or zero growth, or even a contraction and recession, without the ability for a central bank to lower the interest rates further as they did in the past.

Concerning point 2, I thought how not only is it difficult for pensions to diversify since they are forced by law to hold some bonds, but in doing so they would be underfunding governments since there would be less demand for their bonds and debt. With less bid, it is possible that the debt issue could threaten other aspects of government operation, leading governments to seek an increase in taxes, further leading to a contraction or recession since the economy hasn’t really recovered yet, as in point 1.

In Austria, for example, pension funds are required to invest at least 35% of their assets in mortgage bonds, government bonds, and euro denominated debentures. French pension funds must invest a minimum of 50% in EU government bonds. In Denmark, pension funds must invest a minimum of 60% of their portfolio in domestic debt. Finally, in Mexico, pension funds must invest at least 51% of fund assets in inflation-linked or inflation-protected securities, and at least 65% in securities that either have a maturity shorter than 183 days or floating rate notes whose rate is revised in less than 183 days (Source of text) (Source of image)

Concerning point 3, since the overwhelming majority of government bond purchase has been done by the ECB, if they were to suddenly stop doing so, it is very unlikely that the private sector would “pick up the slack” and buy as much as the ECB was purchasing, leading to a skyrocketing of interest rates since there would be little to no bid. As in point 2, this would lead to less funding for governments, and the debt problem becoming worse, potentially leading to an increase in taxes as the only solution, and thus prolonging or worsening the recovery, especially in Europe.

So if we assume the premises above are correct (which they may not be, which is why I am sharing this post for feedback), then I could see some consequences happening:

1. If the debt issue becomes a problem, and the alternatives are potentially counter-productive (raising taxes), then governments may seek an international debt negotiation or pardon
2. The lack of a single european debt policy, or an incentive to start one at this stage, could lead to the collapse of the euro

Concerning point 1, there is certainly historic precedent in the past, however seeking an international debt negotiation or pardon would lower the confidence in the european institutions and governments, leading to increased lending interest rates due to a decreased rating, and further making it harder for governments to fund themselves despite the lower debt, which could further result in a recession.

Concerning point 2, I think I can refer back to the middle of the decade when Greece was having its serious issues and most investors were concerned about systemic risk. Since the debt was not unified in Europe like it was in the United States, it would be hard to maintain a single currency when the individual countries are cornered into a difficult position like in Greece.

A further consequence of point 2 and the potential collapse of the Euro, would be that previous money that was parked in the Euro would move to the US Dollar as it still stands as the world’s reserve currency, and EUR/USD still is the most liquid trading pair in the market. Alternatively, a lesser % of money could flow to other assets such as Commodities, Equities, and alternatives (such as collectibles and cryptocurrencies), which could lead to localized or generalized unsustainable price rises.

The biggest consequence of the money moving from the Euro to the USD would be the huge valorization of the dollar, which would further drive two main consequences:

1. Many countries have contracted debt in USD at a time when the USD was cheaper. If the USD rises, let alone substantially rises, then they will find themselves unable to meet the debt obligations, potentially leading to a worldwide cascade effect of sovereign debt related issues and implosions.
2. A side effect of this would be that a strong dollar would hurt USA’s exports substantially, leading to a slowing down of the economy and potentially triggering a recession. I believe the latest data is that exports represent around 12% of the USA’s GDP as of 2017.

From these points we start getting even more into the speculative realm. All of these events have the potential to trigger extreme social unrest, conflict, and even war. Additionally, they could trigger or speed up the economic/monetary shift from the West to China and Asia, further promoting the decline of the West in terms of past prosperity and influence. This could also lead to a new monetary fund organization with different goals and lessons learned from the events that had unfolded.

I have written all the points above in perfect knowledge that they paint a fairly “alarmist” picture of the future, though I am very open to being proven wrong. This is why I would be interested in discussing these ideas with more people.

Let me know your thoughts below.