How central banks beat back the ‘bond vigilantes’ 

Governments across the world are embarking on the biggest borrowing spree in history, as they look to tackle the coronavirus crisis. That should, in theory, be a happy hunting ground for “bond vigilantes” — hedge funds and other investors that punish free-spending states by betting against their debt, in the expectation that higher issuance will push bond prices down and yields up. 

But investors trying the same trick today look set to get crushed. Faced with unprecedented levels of bond buying by central banks, even those investors who worry about sharp rises in government debt levels are reluctant to take them on.

“In the short term, the idea of being a bond vigilante is dead,” said Iain Stealey, international chief investment officer for fixed income at JPMorgan Asset Management. “There’s going to be massive support for bond markets from central banks for the foreseeable future. You don’t want to fight that, so we’re happy to own [long-dated government bonds].”

Hard-nosed bond investors have scored some notable successes in recent years. As a result of the eurozone debt crisis, for example, investors locked Greece out of the debt markets for about four years, while in May 2018 hedge funds including Brevan Howard and Discovery Capital Management made big gains as Italian bond yields soared on fears that its likely new government would take on more debt and loosen ties with the EU.

But pickings have otherwise been slim, as central bank bond buying has suppressed yields and helped countries keep their cost of borrowing very low.

Line chart of 10-year yields (%) showing Central bank bond-buying has suppressed yields

Some would-be vigilantes had expected coronavirus to give them a new lease of life, so large are the bond issuance plans to fund the response. The UK is borrowing £45bn in April alone, roughly three times its previous schedule for the month, while even Germany’s obsession with balanced budgets has been set aside to allow an extra €150bn of borrowing.

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The market, meanwhile, has endured bouts of volatility, with a brutal sell-off last month as investors liquidated even the highest-quality bonds to get their hands on cash.

But central bankers were able to restore calm with grand support packages — particularly the Federal Reserve’s pledge to buy unlimited amounts of US Treasuries. Borrowing costs in big developed economies are once again hovering close to record lows, suggesting any outbreak of vigilantism has been suppressed for now.

“It seemed like [bond vigilantes] were sticking their heads above the parapet in the last couple of weeks,” said Ed Yardeni, a US economist widely credited with coining the term in the early 1980s. “But ‘QE4 to infinity and beyond’ put a stop to that.”

Mr Yardeni suggests that investors in the US and Europe should look to Japan for what comes next. Tokyo has run large fiscal deficits for decades and seen its debt balloon to 240 per cent of economic output, but continues to enjoy some of the lowest borrowing costs in the world. That is largely because the Bank of Japan has gone further than other central banks, buying as much debt as it needs to keep yields below certain thresholds under a policy known as “yield curve control”.

Yields on 10-year Japanese government bonds (JGBs) have steadily fallen from nearly 2 per cent in 2006 to less than 0.02 per cent today. The futile trade of betting against the bonds has been dubbed “the widow-maker”.

The Fed seems to be edging closer to yield curve control. “The Fed has basically turned into the Bank of Japan,” Mr Yardeni said.

“Are Treasuries and JGBs going to blow up? It may happen in our lifetime, but it’s not a trade I’m going to spend much time on right now,” said Danny Yong, founding partner at hedge fund Dymon Asia Capital.

Some think there will be a moment for bond vigilantes to strike further down the line. Huge asset-purchase programmes may become unsustainable once economies begin to recover, stirring inflation, argues Franklin Templeton fixed income head Sonal Desai.

“Everyone is buying wholesale that pandemics are deflationary,” she said. “They are probably right in the first instance, but what about when everyone comes back to work?” 

The sheer volume of bond issuance could ultimately push investors to demand higher borrowing costs, says Ms Desai, at a time when inflationary pressures force central banks to scale back their purchases. This could create “a massive debt overhang”, she said.

“You need to pick your spots,” said Dymon’s Mr Yong. He thinks countries such as Italy and Spain, which do not directly control their own monetary policy, could provide “sporadic” opportunities, while betting against emerging market bonds “makes a lot of sense. They don’t have the credibility to print [money].” 

Other fund managers agree that big bets on the direction of bond yields will have to wait.

“I don’t believe we are stuck in interest rate quicksand forever and deficits will never matter,” said Steven Oh, global head of credit and fixed income at PineBridge Investments. “At some point this will have to be paid for. But while you are in a crisis situation that’s potentially cataclysmic you can pretty much throw that out of the window.”

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