WHAT COULD TIP THE BOND MARKET EQUILIBRIUM? / THE FINANCIAL TIIMES MARKETS INSIGHT

What could tip the bond market equilibrium?

There are a lot of buyers standing in the way of a reversal

John Plender


It is a scenario that until recently would have struck most observers as downright implausible: a financial cycle in which global debt piles up inexorably while nominal interest rates collapse.

Yet here we are, in seeming equilibrium where $14tn of debt has negative yields, with investors paying for the privilege of lending to governments. The question is how stable and durable that equilibrium will prove to be, especially if we are in a bubble for bond prices.

There is no shortage of warning signs, not the least being the substantial buying by investors who are unconcerned about fundamentals. Chief among them are the central banks, for whom the price of the bonds they have bought since the financial crisis is not a primary consideration.

Also insensitive to price are fast-growing passive bond funds and those pension funds that adopt investment strategies that match their liabilities.

Then there are investors who buy negative-yielding bonds on the “greater fool” theory, with the central banks cast in the role of the fools who will deliver capital gains to these investors through further easing. They are more sensitive to price than to income, as are momentum investors.

Yet the most striking feature of recent bond market flows is how much foreign money has been chasing negative yielding IOUs. Official data aggregated by JPMorgan show that foreign investors bought nearly $210bn of eurozone bonds and $70bn of Japanese bonds in the first half of the year. This compares with a $550bn outflow from March 2015, when the European Central Bank began its “quantitative easing” purchases, to the end of 2018.

The figures for Germany, at the heart of the negative rate phenomenon, are particularly striking. After cumulative outflows of nearly $360bn over this three-year period, there were inflows of more than $65bn in the first half of this year. These are extraordinarily large shifts and seemingly perverse when the pool of eurozone bonds sporting negative rates was expanding rapidly.

Part of the explanation is a quirk in the workings of foreign exchange hedges. These are based on the relative levels of short-term interest rates which are much higher in the US, which has a 10-year government bond yield of 1.8 per cent, than Germany, where the same maturity of government debt trades at minus 0.5 per cent, and Japan at minus 0.2 per cent. Dollar-based investors are in effect paid to hedge their euro or yen exposure back into dollars.

This counter-intuitive carry trading arithmetic has been a very powerful driver of cross-border capital flows. All part of the fun, it seems, of a bond market bubble.

An equilibrium in which debt goes on rising while interest rates continue to fall cannot last for ever. What, then, could unhinge it and cause yields to rise again?

One eventuality is that central banks reach a negative interest rate floor, which must exist as long as there is physical cash in the system. That is the point at which depositors decline to pay fees for lending to banks and withdraw their funds.

An additional constraint on pushing rates further into negative territory is the damage inflicted on banks that are having to pay to keep loans and securities on their balance sheets. Penalising them for extending credit to sustain economic growth cannot be good, as reflected in the depressed price of European bank shares.

These also tell a tale of growing scepticism about the ability of monetary policy to keep the global economic show on the road. A consensus is thus emerging that fiscal policy will have to do more of the work — even, to a degree, in conservative Germany.

Ultra-low interest rates are substantially the result of excess savings in northern Europe and Asia. Expansionary budgets would imply reduced saving by governments, thereby eroding global imbalances.

Other factors that point to a return to higher inflation and thus higher rates include US president Donald Trump’s trade war, which is raising costs as global supply chains are reined back.

There is the possibility, too, that demographic pressure involving the shrinking of workforces in the developed world and in China will lead to renewed wage inflation. This, admittedly, has not happened in Japan where ageing is already advanced, but it is possible that the Japanese workforce is uniquely docile.

Investment, which has been weak in the advanced economies, could pick up significantly as old industries are disrupted by new ones and forced to renew physical capital — the motor industry being merely one among many potential examples. Business will also have to make the huge investment necessary for the transition a low-carbon economy.

That said, the deflationary forces in the world remain far from negligible. It would be a bold person who would happily predict whether rising yields will come before or after the next recession.