The interests of bond holders are no longer perfectly aligned with those of the most powerful constituency. Exhibit 5 shows the rapid increase in the age of the median voter in large western European countries. In principle, having governments and policies shaped by older voters ought to be favourable to bond holders, because bonds are more likely to be held by the old than the young and policies that would harm bond holders would often also harm the old (inflation for instance redistributes wealth from the old to the young). The first problem with this argument is that the constituency of the elderly is also the biggest competitor to bond holders because of the considerable size of the direct claim it has on the government balance sheet in the form of pensions, social security and health insurance, etc. The more reluctant they are to relinquish these claims, the higher the risk for bond holders. The second problem is the dilution of bond ownership, which results in lesser alignment of the interest of bond holders with older voters: even in the UK, where the domestic and pension industry has traditionally dominated the gilt market, its ownership of gilts has decreased in recent years from around 60% to 40% of the market excluding Bank of England purchases), to the benefit of foreign investors.

No insurance against financial oppression at current yield levels. Against this background, it seems dangerously optimistic to expect that sovereign debt holders can be continuously and fully sheltered from partaking in the loss of wealth and income that has affected every other group. Outright sovereign default in large advanced economies remains an extremely unlikely outcome, in our view. But current yields and break-even inflation rates provide very little protection against the credible threat of financial oppression in any form it might take. Note that a double-dip recession would not invalidate this conclusion: it would cause yet further damage to the governments' power to tax, pushing them further in negative equity and therefore increasing the risks that debt holders suffer a larger loss eventually.

Eoin Treacy's view This article by Arnuad Mares for Morgan Stanley appeared in John Mauldin's Outside The Box eletter and may be of interest to subscribers. Here is a section from the conclusion:

The interests of bond holders are no longer perfectly aligned with those of the most powerful constituency. Exhibit 5 shows the rapid increase in the age of the median voter in large western European countries. In principle, having governments and policies shaped by older voters ought to be favourable to bond holders, because bonds are more likely to be held by the old than the young and policies that would harm bond holders would often also harm the old (inflation for instance redistributes wealth from the old to the young). The first problem with this argument is that the constituency of the elderly is also the biggest competitor to bond holders because of the considerable size of the direct claim it has on the government balance sheet in the form of pensions, social security and health insurance, etc. The more reluctant they are to relinquish these claims, the higher the risk for bond holders. The second problem is the dilution of bond ownership, which results in lesser alignment of the interest of bond holders with older voters: even in the UK, where the domestic and pension industry has traditionally dominated the gilt market, its ownership of gilts has decreased in recent years from around 60% to 40% of the market excluding Bank of England purchases), to the benefit of foreign investors.

No insurance against financial oppression at current yield levels. Against this background, it seems dangerously optimistic to expect that sovereign debt holders can be continuously and fully sheltered from partaking in the loss of wealth and income that has affected every other group. Outright sovereign default in large advanced economies remains an extremely unlikely outcome, in our view. But current yields and break-even inflation rates provide very little protection against the credible threat of financial oppression in any form it might take. Note that a double-dip recession would not invalidate this conclusion: it would cause yet further damage to the governments' power to tax, pushing them further in negative equity and therefore increasing the risks that debt holders suffer a larger loss eventually.

My view - Politicians don't like to talk about unfunded pension, healthcare and social security liabilities because the numbers are so frightening. If they were to really decide to tackle these developing problems it would probably result in a pretty short career because some mix of much higher taxes or a massive curtailment in the services offered would have to be adopted. Since those who depend on government largesse to fund their lifestyles get to vote, these have been touchy issues for quite some time in most countries.

Everyone knows that if it is impossible for a government to keep the promises it has made to pay for public service pensions, social security, healthcare and bond liabilities then it will end up paying what it can afford. This probably means the eventual demise of early retirement, higher overall retirement ages, rationalisation of healthcare provision, less social security as well as higher taxes.

Bond holders need to bear in mind that the classic response of government to a massive debt burden is to pay it off in a debased currency either through high inflation or an outright devaluation. For the USA, since most of its debt is held by foreigners just how debts are to be paid back is a sensitive issue. Rather than curtail deficit spending and social liabilities, the USA has so far done the opposite. This can be justified at least in part by claiming that government largesse makes up for the fall off in the velocity of money but is contingent on the munificence of its creditors.

Europe has similar if not bigger debt problems and has an equally significant interest in a weaker currency which has resulted in a competitive devaluation that has resulted in the outperformance of those less affected by excessive government and private sector debt such as those in Asia. The exception has been Japan which is only now tackling the strength of the Yen.

Peripheral Eurozone countries owe a fortune to the Eurozone core. Without the pressure release valve of debasement peripheral nations have been forced to adopt a massive fiscal consolidation. However, it remains to be seen just how willing respective populations are to accept such restrictions over a lengthy period of time. At some point they may decide to demand easier credit conditions in return for not defaulting. This is a nuclear option but since German, French and UK banks are so exposed to the periphery it is hard to see how they would refuse an even bigger rescue package if it was needed to avoid default.

The Greek bailout was arranged to avoid just this scenario but other countries may yet need assistance and it looks as if the core Eurozone will have no choice but to come up with the capital needed. Against this background, government bonds, which have seen supply multiply over the last couple of years, are far from a safe haven asset.

US Treasuries pulled back sharply from the late August high near 137 and found at least short-term support in the region of 130 from which the contract is now rallying. While this is the largest reaction by far in what has been a very consistent uptrend, the step sequence consistency remains in place and prices will need to encounter resistance below or the in the region of the August peak to confirm the bearish hypothesis.

Eurobunds hit a near-term peak just below 135 three weeks ago and pulled back into the previous range. Today's rally breaks the short-term progression of lower highs and likely signals at least a partial unwinding of the short-term oversold condition. As with Treasuries above it will need to encounter resistance below or in the region of 135 to confirm the bearish hypothesis.