Central banks may not have bond barrage covered yet
The central banks have everyone’s backs, right? Perhaps not yet.
(Retuers) As governments set about borrowing trillions to fund the financial bridge over pandemic lockdowns, the market assumption is that the central banks will keep new debt piles affordable by flooring interest rates and buying, or pledging to buy, large swathes of the new bonds being sold.
That’s certainly the “whatever it takes” message from the major monetary policy chiefs, calculating that at least keeping “real” inflation-adjusted borrowing costs deeply negative for the foreseeable future will make the debt explosion sustainable until there’s a return to vigorous growth.
So far, so good. Global long-term government bond yields have more than halved to all-time lows since the virus hit, despite the looming tsunami of new bond sales that will likely take total debt as share of national output well in excess of 100% for the G7 economies as a whole.
But amid a blizzard of often confusing and overlapping pandemic rescue programmes and central bank supports, just how do bond market mathematics shape up for the rest of the year?
JPMorgan’s investment flows specialists took a stab at the overall global picture this week by updating estimates of bond sales versus likely demand, and concluded that anticipated central bank buying is just about enough to match debt supply.
But they warned: “Central bank QE might need to be upsized from here to prevent a rise in bond yields, especially if there is further fiscal stimulus or if our projections for private sector bond demand prove optimistic.”
Overall, they estimate bond sales from the G4 governments - the United States, euro zone, Japan and Britain - will increase by $2.1 trillion this year, aside from Treasury bill sales. On the flipside, likely demand from banks, pension and insurance funds, retail investors and reserve managers is expected to drop by 2.1 trillion over 2019.
That leaves a $4.2 trillion-sized hole - which, as of May, is set to be filled by $4 trillion in central bank buying. In other words, with the caveat that oodles of assumptions, proxies and modelling can’t be precise, the net picture looks to be about $200 billion shy on those metrics.
Given the scale of the support plans already announced, it’s not difficult to see central banks step up to fill that void over the coming six months. The ECB, for one, is likely to have to expand its pandemic relief programme by October anyhow.
But government spending and borrowing too may be forced to rise over the coming months, and heavy bond sales will likely continue well through 2021 to fund this year’s massive rescue as well as meeting calls for post-pandemic stimuli.
TERM PREMIUM SHOCK?
Yet, even assuming this basic net supply/demand math is easily squared, there are some who think upward pressure on borrowing rates will build regardless.
In a note entitled “The Coming Attack on Bonds”, liquidity specialist Michael Howell’s CrossBorder Capital said this week that it saw a surge in the supply of “safe” assets - U.S. government bonds - as a concern.
“The very act of injecting liquidity and, by definition, reducing systemic risks and lowering default rates must dent the private sector’s need to hold safe assets,” it wrote.
“This is what drives ‘term premia’ and, from history, the scale of the policy impulse could easily add 150bp to long-dated U.S. yields,” it said, adding such a situation could see 10-year Treasury yields test 2.0%.
The so-called term premium in bond markets is a slightly slippery concept but is defined as the excess return investors demand for holding, say, a 10-year bond rather than simply buying 12-month bills and rolling them over every year for 10 years.
In effect it captures an uncertainty premium to cover the length of bond maturity, above and beyond simple future interest rate and inflation assumptions. Governments and central banks broadly want lower premia as they have historically made up a sizeable chunk of a country’s borrowing costs.
The odd thing about the U.S. Treasury’s term premium has turned negative over recent years - with massive private investor demand for such long-term “safe” assets a factor.
CrossBorder’s rationale is that the demand for these safe assets has significantly outstripped supply since the banking crash of 2008-09, partly due to austerity policies in many major economies and a surge in private debt levels.
It reckons this shortfall may total as much as a 85% of world gross domestic output and the U.S. Treasury borrowing surge could close the gap to around 30% of GDP by year-end.
CrossBorder, which reckons the shortfall in safe-asset supply is behind the unusually low bond term premia, cited New York Fed research showing three-quarters of recent moves in 10-year Treasury yields can be explained by these term premia.
Going back to 1961, CrossBorder calculates each 10% growth in “safe” asset supply leads to a 54bp rise in 10-year term premia.
Judging by current market behaviour - or indeed the behaviour over the past 10 years - this looks like an outlier of a view. But it reinforces the idea that to keep this government debt surge sustainable, central banks may have to do a lot more.