The great bond shortage?
The world’s largest debtor, the US government, has announced that its finances are sufficiently healthy for it to be in a position to repay some of its debt over the course of this year. Although many European governments are looking to raise similar amounts to last year as economies emerge from deep recessions, the stated strong desire here is to keep tight holds on fiscal purses.
The big exception to this budget deficit-shrinking trend is Japan, where frailty of the economy and doubts about the sustainability of its recovery mean that the Japanese government is keeping fiscal policy extremely accommodative, and the already huge budget deficit is forecast to come in this year at 10% of GDP.
Even including Japan, however, gross global government bond issuance this year is forecast to come in at $1.4trn (e1.4trn), the lowest amount since 1994.
The US federal budget moved out of the red in 1998, for the first time in 28 years. In the next fiscal year it is forecast to be in surplus to the tune of $184bn. A budget surplus does not, in itself create headaches for bond investors – quite the contrary as it is normally associated with strong fiscal prudence. However, recent pronouncements from various Fed officials, on the subject of its planned buy-back operations, has created considerable uncertainty in the Treasury market.
Jonathan Cunliffe at Lombar Odier agrees, “There is certainly much confusion in that market. Larry Summers, the US treasury secretary, has tried to clear it up but the market is only slightly less convinced that the bulk of buybacks will be concentrated in the 15-year and over maturity range. If you’re going to buy debt, yours or indeed anybody’s then you choose the highest yielding – and currently that’s at the 2015/16 maturity end. And the market is changing. We look at basis volatility, between the 30-year Treasury and long bond future, as a gauge of market appetite for risk. It has risen markedly, and we believe this to be a sign of the increasing reluctance of the trading community to ‘play’ in this arena. There is a diminishing appetite for risk and no-one is chasing it.” Cunliffe believes this lack of risk-taking may be an overhang from the troubles of certain hedge funds and the trading community at large, but thinks it may also be linked to the uncertainty concerning the future of the long bond and its status as a key benchmark.
There has been little economic news to suggest that inflation expectations should be lowered, although over the past month the US Treasury yield curve has inverted between the 10-year and 30-year sectors, as the long end rallied while short rates either remained unchanged or rose slightly. Significantly, much of the 30-year’s rally occurred in the days following the Fed’s initial buyback announcement.
Andrew Wealls, head of fixed income strategy at Barclays Global Investors, suggests that the yield curve changes are not reflecting an improved outlook for inflation, and that other technical forces have been at work. He suggests: “We do not believe that the long end of the market is expecting inflation of 1%, compared to a 10-year view of 2%. It is real yields that have changed, reflecting the changing supply/demand equilibrium.”
In the UK supply and demand technicals have virtually overwhelmed fundamental valuations at the long end of the gilt market. As long as the UK government keeping its tight hold on the fiscal purse, supply is unlikely to be increased, unless the Debt Management Office (DMO) over-funds or chooses to do all its funding at the long end. Demand will continue strong as long as pension funds and insurance companies are ‘obliged’ to match their long term liabilities with long term government bonds only.
Wealls points out that it is not a unique idea for governments to announce that they will completely pay down debts, and he is reminded of the UK government’s plans to do just this in the late 1980s. At that time there were big plans to repay the whole outstanding stock of gilts within a decade. However, the recession of the early 1990s left a £50bn (E82bn) and saw huge volumes of new gilt issuance.
He is sceptical that the dogma of fiscal discipline seen in the 1980s and again in the late 1990s will be strong enough to completely withstand the impact of deep recession and believes that governments will loosen fiscal policy and become net issuers of debt.