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Puerto Rican Default, Plunging Sovereign Yields, and Brexit Fallout Creating Perfect Storm for Gold
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Just as the initial reaction from the shock Brexit leave vote started to cool off, another familiar old spectre has raised its head to threaten American and potentially global financial markets. This is the rapidly deteriorating financial position and ongoing bond defaults in Puerto Rico. On the one hand bond yields are soaring there while on the other they are cratering to zero and even sub zero levels around the European Union and the rest of the developed world. In both cases, gold is the main beneficiary as prices are now up an impressive 27% year to date.
Puerto Rico Largest Yet Default Threatens Bond Markets
Sadly Friday's latest Puerto Rican bond payment failure is only the most recent instance of default from the American commonwealth island since May 2 when the Government Development Bank defaulted substantially on the $367 million they owed their bondholders. The most recent occasion is worrisome for two main reasons. The amount in question on Friday, July 1st was a hefty $2 billion. More concerning still is the fact that over $1 billion of this amount is a part of the island's general obligation bonds. These particular bonds represent the little island's highest tier of credit, complete with a constitutional tie to the island's revenues. In the end, the governor himself Alejandro Padilla came out with an executive order the day before they were due suspending all payments on these general obligation bonds in question. While Moody's claims that Puerto Rico has already defaulted on $562 million in debt service payouts since last August, this government obligation bond default is the first of its kind on bond securities that bear the first priority for repayment under the constitution of Puerto Rico. Many investors and bondholders held out false hopes that the government would pay out the interest on the bonds at least. In the end, the Governor's dire warnings that the island would default on in excess of $1 billion in general obligation bonds proved to be true.
Help may finally be on the way for the beleaguered island commonwealth. Congress and the Senate have finally passed and President Obama signed into law the PROMESA Puerto Rico Oversight, Management, and Economic Stability Act. The act does not bail out Puerto Rico by any means though. It merely sets out a path for the creditors and the commonwealth to be able to work out an orderly restructuring of the $70 billion massive debt that Puerto Rico owes. It buys them some breathing space by staying any litigation and lawsuits from the government's bondholders.
Meanwhile, the biggest three insurers of these island government bonds are bearing the brunt of the default, which always adds to the risk of hidden contagion between these and other re-insurers. Ambac, Assured Guaranty, and National between them hold over $800 million in exposure to the payments missed Friday. The government obligation bond payments were backed by Assured Guaranty to the tune of $196.5 million and MBIA through its wholly owned subsidiary National in the amount of $173 million. The three insurance companies between them were on the hook for nearly a billion in losses from Friday's financial blood bath. Only time will tell if other insurance and reinsurance companies will be contagiously affected by these substantial losses.
Negative Global Bond Yields Pushing Up Gold Prices
On the opposite side of the bond spectrum, continued quantitative easing from both the European Central Bank and the Bank of Japan has led to near zero to sub zero yields on global bonds in a number of developed countries. This in turn has helped to push gold up to two year highs at near $1,350 per ounce. The safe haven metal is already up around 27% on a year to date basis. While the all time high still sits at over $1,900 an ounce from August of 2011, there are fund managers calling for a new high in gold sometime in the coming 18 months.
Juerg Kiener, Chief Investment Officer and Singapore Managing Director of Swiss Asia Capital points out that the crashing of sovereign bond yields is negating the little advantage that fixed income vehicles boasted versus gold. Gold may not offer any yield or interest, but it still is more attractive than assets which charge to hold them as with these now negative yield sovereigns. Besides this, a continued decline in investor and individual confidence in the establishment and their governing policies is boosting the safe haven metal. The latest demonstration of disillusionment with the global governing elites was the June 23 UK referendum where voters opted to part ways with the European Union. While governments dictate the entire fixed income market that has become negative, gold is not threatened by new supply as no government can print it, and it suffers from declining production.
Fallout in the UK and US From Brexit EU Departure Continues
Gold is also receiving a significant boost from the continuing fallout in both the UK and now the US from the Brexit impending departure from the European Union. British Chancellor George Osborne is now going to cut the country's corporation tax to under 15% in his latest effort to counter the blow to investors in the country, per the Sunday edition of the Financial Times. Meanwhile in the U.S., the Markit Purchasing Manager's Index declined precipitously in June from May's 51.2 to 46.0. This is the lowest point in the index since June of 2009. Under the 50 level signifies contraction in the economy. The lesson from all of the instability going on in the world these days is clear. Keep your friends close and your gold closer.