Calm has descended across one of the most influential markets for all investors: government bonds.
Investors fearing a rolling interest rate shock unfolding in 2021 with the potential for puncturing high-flying equities, housing and highly indebted economies have been breathing easier of late.
Courtesy of central banks’ sustained presence in bond markets, this year’s rise in market borrowing costs has not triggered a bigger shock at least for now.
Expectations of a punchy restoration of economic activity back in January was the trigger for the US 10-year benchmark rising from below 1 per cent to a peak of 1.77 per cent during the first three months of the year. After that rapid market shift, a period of consolidation has played out with the US 10-year idling this week near 1.60 per cent.
The present tone of relief in bond land has not been ruffled by the evidence of hotter inflation readings, or hints from central bank officials that they are looking at a “taper” or a reduction in their brimming punch bowl of monetary liquidity.
The US central bank is still purchasing $120bn of Treasury and mortgage debt each month and its balance sheet has doubled in size to $8tn from the start of 2020. Its overall holdings are seen reaching $9tn by 2023, or 39 per cent of GDP according to estimates published this week by the Federal Reserve Bank of New York.
There is another powerful explanation for why bond market rates are steady and could well handle a gradual reduction in central bank buying. The current level of interest rates endorses the view of Fed officials that hotter consumer price pressure will prove transitory.
The US 10-year benchmark yield is only seen climbing to 1.90 per cent by the end of this year and to 2.17 per cent when the calendar flips into 2023, according to economists surveyed by Bloomberg this month.
That looks low when gauging the trajectory of the economic recovery and the ongoing boost from stimulus. In the wake of the financial crisis, the 10-year yield rose above 3 per cent and stayed there until mid-2011. Today’s bond market appears confident that any eventual tightening of financial conditions will be slow and measured, illustrated by the current pegging of interest rates for the next five years below 1 per cent.
But a sense that something does not seem right within markets is perhaps best explained by how a financial system that has enjoyed substantial support from central banks is inherently less robust. Both equities and housing are asset classes for example that have appreciated substantially in a climate of cheap borrowing costs.
“The paradox is that the more successful central banks are in driving up valuations of risky assets using stimulus, the harder it becomes for them to exit,” said Matt King, global markets strategist at Citigroup.
An important US policy lesson from 2018 was that even a modest tightening in financing costs became very uncomfortable for equities and credit markets. While there are grounds for the economy being supported by fiscal stimulus and therefore sparing housing and equities from being hit hard by higher interest rates, King said: “It is much more likely that rising yields prove destabilising as there is more debt outstanding.”
Assessing the “great unwind” of monetary and fiscal support features prominently in the latest edition of the annual Barclays Equity and Gilt study on long-term asset returns in the UK and the US.
The bank wrote this week that the restoration of activity after the pandemic “raises questions about the degree that support will be withdrawn”. Among various scenarios, they said, “the risk of disorder seems meaningful in the US, where policy responses have been especially forceful” and “the prospect of a messy unwind could emerge for the Federal Reserve”.
Barclays focuses on an issue that is top of many investor minds at the moment: the trend in “long-term inflation expectations”. Should this bond market measure rise meaningfully and become “unanchored” after 2021’s “transitory” supply chain ructions, it “would likely involve painful trade-offs between prolonged unemployment and longer-term inflation”.
Maintaining central bank credibility on stemming entrenched inflation would require a sharp rise in interest rates that hits the economy and in all likelihood asset prices. What Barclays calls “a more balanced approach” would involve the central bank tolerating “a longer and shallower recession that is accompanied by more prolonged inflationary pressures”.
While interest rates presently slumber, investors should be mindful that the fortunes of highly valued equity and housing markets rest on just what kind of central bank exit strategy eventually unfolds.
“The Fed says it has the tools to fight inflation, and it does,” said Steven Blitz, chief US economist at TS Lombard. But a question also awaits answering he said: “Is it willing to accept the end of capital market pricing distortions that their policies have created?”
Unhedged — Markets, finance and strong opinion
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