Investors are worried that Western governments are issuing more bonds than investors can buy. Whether the system that transacts in those bonds can bear the load could be a much more urgent issue.
Last week, the U.S. Treasury Department said it would issue longer-term debt. Ten-year and 30-year government-bond yields, which had recently touched 16-year highs, have since fallen sharply.
Bond investors across the globe have been particularly jumpy about increases in public-debt supply. The implied threat is that, amid higher inflation and interest rates, they are no longer willing to unflinchingly absorb it. Government debt in rich countries is set to hit 116% of gross domestic product in 2028 from 112% in 2022, the International Monetary Fund forecasts, as officials increase spending on industrial plans and green policies.
Yet the end-buyers of the debt are unlikely to disappear since government deficits automatically create the very savings that are then channeled into financial assets. The real issue is that the financial plumbing meant to make all this happen has become dangerously creaky.
The Federal Reserve’s primary dealers—the banks that buy the bonds in auctions and then make markets for them—are the linchpin of this system in the U.S. Before the 2008 financial crisis, they were net sellers of Treasurys, official data show, meaning they actually had to borrow bonds from investors. Ever since, the surge in debt issuance has forced them to buy more Treasurys than they can sell.
It therefore makes sense for the U.S. government to cut back on long-term issues. For 30-year Treasurys, borrowing costs are now 0.6 percentage point higher than swap rates.
The other problem is that postcrisis financial regulations prevent banks from limitlessly absorbing bonds. Central banks’ “quantitative easing” was picking up some of this slack, but no longer: The Federal Reserve and the Bank of England are actively selling bonds, and the European Central Bank might soon stop reinvesting the proceeds from its pandemic purchases.
Another less-regulated type of player is stepping in: hedge funds. Figures by the U.S. Commodity Futures Trading Commission show that bets by leveraged investors against Treasury futures are hovering around an all-time high, likely due to them acting as dealers by buying Treasurys and selling Treasury futures.
But, as the Basel-based Bank for International Settlements warned in a September report, this is a risky trade that can quickly unravel. When Covid-19 concerns hit in March 2020, Treasurys sold off. Investors were shocked because a haven asset is expected to appreciate in times of trouble. Funds and dealers shedding leverage had the opposite effect.
Matters are a bit different abroad. In Japan, central-bank bond buying continues, despite recent tweaks. In the eurozone, German austerity has limited the supply of ultrasafe bonds. In the U.K., regulators created insatiable hunger for long-term securities among pension funds, which nonetheless imploded last year in spectacular fashion, leading to the ouster of Prime Minister Liz Truss.
Nevertheless, the takeaway applies everywhere: The private sector may not be able to provide as much bond-market liquidity as officials’ fiscal plans imply.
Buy-and-hold investors could safely take up more of the load. However, U.S. dealer positions are historically negatively correlated with the steepness of the Treasury yield curve, meaning that such real-money buyers step in only when bond returns significantly exceed those of leaving cash in the bank. This has started to happen: Stretched dealers have priced long-term bonds at a discount, which has resulted in an increase in the “term premium,” leading to higher borrowing costs and a disgruntled equity market. There may be more to come.
“It can take a while for these holdings to rebalance in response to the changing investment opportunity,” said Du, who is a professor of finance at Columbia Business School.
To be sure, the solution is in officials’ hands. They could help banks sidestep regulatory costs by promoting “sponsored” repurchase agreements. Or they could allow for certain exemptions from leverage rules, like the Fed and the ECB did during the pandemic. In September, the BOE announced a liquidity facility for nonbank financial firms. Eventually, central banks would buy bonds again. But backstops kick in only after severe market disruptions.
It may turn out that the “bond vigilantes” aren’t as dangerous as the “bond warehouse managers.”
This article was originally published in The Wall Street Journal on November 6, 2023, and written by Jon Sindreu/Photo: Nathan Howard/Bloomberg News
Spectrum Wealth Management, LLC is an investment adviser registered with the U.S. Securities and Exchange Commission. Registration does not imply a certain level of skill or training. Additional information about Spectrum’s investment advisory services is found in Form ADV Part 2, which is available upon request. The information presented is for educational and illustrative purposes only and does not constitute tax, legal, or investment advice. Tax and legal counsel should be engaged before taking any action. The opinions expressed and material provided are for general information and should not be considered a solicitation for purchasing or selling any security.