A big problem looming for bond markets
Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
The writer is chief European economist at T Rowe Price
Does the supply of bonds affect the level of yields? The answer is a firm no, according to a popular theory of bond valuation. This argues that long-term interest rates are just the average of future short-term interest rates — which is a good description of the yield curve in normal times. But that is not the state of the world we are in today.
Sovereign debt demand from the public sector and regulated entities has been unprecedented in the past decade. Quantitative easing programmes of bond buying since the financial crisis to support economies and markets led central banks to raise their share significantly of domestic government debt. Foreign monetary authorities bought G7 government bonds as part of their foreign exchange reserves. And demand from banks rose as a result of liquidity regulations following the Basel III reforms.
For all these reasons, the private sector had only to absorb a trickle of sovereign debt issued, even during the height of the Covid-19 pandemic when a huge rise in public sector deficits was accompanied by a massive increase in QE.
This has significantly distorted major bond markets. The Bank of Japan owns more than 50 per cent of the Japanese government bond market. Only around 20 to 40 per cent of Germany’s Bund market is available for private investors. One sign of such distortions: 10-year Bund yields traded deep into negative yield territory as recently as two years ago.
And since private investors arbitrage yield differentials across G7 bond markets, these distortions have probably pulled yields lower across the world — even in less distorted markets. This large presence of price-insensitive buyers reduced uncertainty about future yield levels. As a result, so-called term premia collapsed across the world. This is the extra return for investors for taking on interest rate risk over longer periods. Such distortions also probably affected markets’ ability to price and indicate R star — the interest rate level at which monetary policy is just right to keep the economy at an equilibrium level: not too tight or too loose.
But these tailwinds have come to an end. On the demand side, major central banks are now in quantitative tightening mode: government securities are either sold actively or maturing bonds are not reinvested any more. At the same time, governments are issuing large amounts of debt due to large deficits.
But this time around, central banks — the price-insensitive buyers — are mostly not in the market. The private sector now has to absorb a large amount of new sovereign debt. The theory that describes the curve well in normal times says that this should not matter for the level of yields. But yields are determined by the marginal buyer, which will now be the price-sensitive private sector.
In this new world, bond supply can affect the level of yields through term premia. A rise in outstanding bonds will raise the share of private sector ownership, as central banks are not in the market any more. But private sector investors have many other options when it comes to purchasing bonds. So yields have to rise to become more attractive.
For example, primary dealers purchased 18 per cent of the total amount at a recent 30-year US Treasury auction, relative to the average take-up of 11 per cent in the past two years, because other private sector buyers stayed away. This signal of weak demand led to an immediate rise in US bond yields. These dynamics become even more important when all G7 governments are issuing a glut of debt at the same time. Then private investors have a much wider choice of what to buy. To attract them, bonds of countries with the same default risk will need to offer higher yields. This is an important reason for the recent rebound in term premia.
Expectations of future large bond supply have similar effects on term premia. In 2022, US government bonds recorded their biggest losses since 1871. As a result of this and an expectation of a lot of issuance to come, investors will be cautious about holding an excessive amount of government bonds. This uncertainty about the future level of yields as a result of higher expected issuance contributes to higher term premia today.
In some countries, such as the UK and the US, term premia have already reached levels last seen before the 2008 financial crisis. However, given the large amount of issuance, QT and investor caution about future yield levels, term premia could easily rise further from the levels we see today. Governments and investors need to be aware that in current circumstances, bond issuance is an important determinant of yields.
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