Global central banks are buying fewer sovereign bonds today than they were a year ago. Meanwhile, governments still need to issue debt to fund their deficits, which ultimately means a greater supply of bonds in the hands of the private sector. A new source of demand will need to emerge, and unlike central banks, which are indifferent to price, this new group will likely be incrementally more sensitive to prices and less inclined to purchase bonds at uneconomic yield levels.
In 2016, the ECB and BOJ purchased such a large quantity of bonds that net annual issuance available to private investors was negative despite the fact that their governments continued to run deficits. This means that the combination of sovereign maturities and central bank purchases more than offset new issuance, thus reducing supply available to everyone else. Today, as central banks start to step away from the bond market, this phenomenon of net negative issuance is slowly turning the other way. As illustrated in the chart below, all three major economies, US, Europe, and Japan, are moving away from supply constrained sovereign bond markets to ones with incrementally more net issuance.
Starting first with the US, net issuance is forecasted to increase as the Federal Reserve begins to shrink its balance sheet and the government continues to spend more than it takes in. The market is largely anticipating this shift. The Federal Reserve laid out an extensive plan in June which indicated it would slowly stop reinvesting bonds that mature, thus letting the balance sheet gradually shrink by a few hundred billion dollars a year. This plan was finalized at the September FOMC meeting, with the process slated to begin in October. In Japan, the shift from bond purchase targets to “yield curve control” has allowed the BOJ to slow its rate of balance sheet expansion, and while net issuance is likely to remain negative, it will be much less negative than in 2016. Finally in Europe, the ECB is inching closer to reducing its pace of purchases from its current clip of ~60bln Euros per month.
This shift from negative to positive net issuance will be a gradual process but one backed by improving fundamentals and above-trend growth across the three major economies. In Europe and Japan, core inflation is inching higher, albeit from a low base. Core inflation in Europe has doubled from a rate of 0.6% YoY in April 2015 to 1.2% today, and much of this improvement has come in the last six months. In Japan, CPI ex fresh food has risen from -0.5% YoY in September of 2016 to 0.5% YoY in July of 2017. Lastly, in the US, inflation may have disappointed this year, but the August CPI report showed signs for optimism going forward.
One outstanding question is the impact this shift will have on yields. In the chart below, real yields appear to be depressed as a result of bloated global balance sheets. Five-year real yields in the US are currently trading around 0% even though real growth has accelerated to 3.1% in the 2nd quarter and the Fed has raised rates a total of four times so far in this cycle. Perhaps the impetus to higher yields is the forthcoming change in the velocity of balance sheet purchases. While the amount of bonds held on central banks’ balance sheets still remains large, the flow is finally turning from expansion to contraction. Term premiums, which central banks have ultimately sought to compress by buying bonds in the first place, should theoretically be free to rise over the next few years with greater net supply.
It is important to note that this analysis has been done in a vacuum, where all other supply and demand factors remain unchanged. Negative interest rates around the world are still a powerful force, creating a reach for yield. Additionally, reserve managers have begun to re-accumulate developed market debt holdings as capital flowing into emerging market countries gets re-cycled back into dollars. Nevertheless, as the global economy continues to strengthen and central banks remove accommodation in a synchronized fashion, it is evident that the dynamics in the bond market are beginning to shift.
When markets start to price this shift remains undetermined. Perhaps yields will only gradually rise until the Fed really ramps up its balance sheet reductions to the maximum cap amount of $50 billion per month. Or perhaps higher yields will require the ECB to finally announce it is stepping away. Regardless, in my mind the seeds have already been planted for this shift to occur, and it is simply a matter of how soon we see the results.
See more writing on this topic by my colleague Andrew Norelli: Stock, Flow or Impulse?