It’s anybody guess which way the US$100 trillion bond market will go
‘The prospects for global bonds are likely to hinge on the actions of the European Central Bank’
For a sign of the extent to which conditions in global debt markets remain favourable, look no further than Greece’s sale of a five-year bond earlier this week.
On Tuesday, Greece, which labours under the heaviest debt burden in Europe as a share of GDP, returned to the international bond markets for the first time since 2014 with a US$3 billion sale of 5-year paper at a yield of just 4.6 per cent, a far cry from the punitive level of 35 per cent in 2015 when it looked like Greece was about to crash out of the eurozone.
This is the latest example of the remarkably benign conditions in debt markets over the past several years in the face of a rise in interest rates in the US and, more recently, signs that other leading central banks, in particular the European Central Bank, are preparing to edge away from the ultra-loose monetary policies that have sustained a 30-year-long rally in bonds.
As the Bank for International Settlements (BIS), the so-called central bankers’ bank, noted in its annual report published last month, monetary “policy normalisation has never been a question of “if” but rather of “when, how fast and to what level”.” The BIS says the world’s major central banks face an acute dilemma: “there is a risk of acting too early and too rapidly”, but also “a risk of acting too late and too gradually.”
It is the uncertainty surrounding the removal of monetary stimulus - particularly the consequences for the prices of government and corporate debt in both developed and developing economies which have been, to varying degrees, distorted by aggressive programmes of quantitative easing (QE) - that is at the heart of a fierce debate among international investors over the outlook for the nearly US$100 trillion global bond market.
That there are such divergent views about how fixed-income will fare in a post-QE world is itself a recipe for volatility, which has been extremely subdued ever since the acute phase of the eurozone crisis came to an end five years ago this week.
The bond bears are convinced that the process of unwinding some US$13 trillion of debt amassed by the Fed, the European Central Bank and the Bank of Japan over the past eight years is bound to put global bonds under severe strain given the three central banks’ crucial role in underpinning the market, particularly in Japan where the Bank of Japan’s share of the government bond market has reached nearly 45 per cent.
The bears point to the 2013 “taper tantrum” as a foretaste of what is likely to happen once Europe and Japan retreat from QE, increasing the scope for policy missteps and overreactions in markets. Given the acute sensitivity of investors to the slightest hint of a withdrawal of stimulus, the risk of a steep and sudden falls in bond prices is significant, particularly given how low yields have fallen. According to JPMorgan, the global stock of negative-yielding government debt - all of it in Europe and Japan - currently stands at nearly US$9 trillion.
For the bears, the bond market is in for a nasty shock.
The bulls, however, believe the leading central banks, especially the European Central Bank, are terrified of triggering a disorderly sell-off and are already going to great lengths to prepare markets for what they insist will be a gradual and well-telegraphed exit from QE. In its mid-year Global Investment Outlook, Blackrock, a large asset manager, argued that policy normalisation is likely to be a process “akin to crossing the river by feeling the stones”.
Bond bulls also point to persistently subdued inflation rates in the US, Europe and, in particular, Japan which limit the scope for policy tightening. Moreover, yields are being held down by structural factors such as a global savings glut, ageing populations and declining productivity.
While the Fed gave further hints on Wednesday that it will start unwinding its US$4.5 trillion balance sheet as early as September, the prospects for global bonds are likely to hinge just as much - if not more - on the actions of the European Central Bank.
The country to watch is debt-laden Italy, which accounts for 17 per cent of Europe’s economy and whose vulnerable debt market would have collapsed a long time ago had it not been for the European Central Bank’s ultra-loose monetary policies.
It was Italy’s woes in 2011 which were the trigger for the biggest spike in the Vix index, Wall Street’s “fear gauge”, since the 2008 financial crisis.
Crossing the Italian river while feeling the stones could prove a lot more difficult for the European Central Bank.
Nicholas Spiro is a partner at Lauressa Advisory