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Can Government Bond Market Signals Still be Trusted?

As the daily noise in the financial markets continues to focus on every word uttered by a central banker, this writer has found himself increasingly being asked the following question by thoughtful investors.

Are negative real rates a reflection of monetary manipulation rather than an indication of weakening growth and related deflationary pressures?

The real yield on 10-year Treasuries, as measured by the 10-year Treasury-Inflation Protected Securities (TIPS), hit a record low of minus 1.22% on 4 August and is now a negative 0.90%.

US 10-year TIPS yield (real yield)


Source: Bloomberg

This is indeed a pertinent question and there is not a simple answer.

The view here, for now, remains that the US Treasury bond market is a real market whose price signals should be respected.

So if the bond market stages the sort of rally seen between April and July, it raises the question of whether the market is sending the signal that the deflationary trend is reasserting itself, against the backdrop of ever higher debt levels, after the “transitory” surge in inflation triggered by the re-opening.

The charts can be found to rationalise such an interpretation, as reflected in the chart below of the loan-to-deposit ratio of the American commercial banking system which was at an all-time low of 59.6% in late September.

US commercial banks’ loan-to-deposit ratio

Source: Federal Reserve

The Evidenc of Treasury Manipulation is Growing

Still, it is also the case that the evidence of manipulation is growing.

This is not just the question of the growing number of institutions, be they banks or insurance companies, which are forced to own government bonds in their respective jurisdictions, but also the growing ownership of government bonds outstanding by the central banks themselves.

This trend is clearly most advanced in Japan where a formal policy of yield curve control has been in place since 2016. The Bank of Japan’s ownership of the outstanding JGBs has risen from 7.3% at the end of 2009 to 48.2% at the end of 2Q21.

Bank of Japan ownership of JGBs

Source: Bank of Japan – Flow of Funds Accounts

The same trend is also becoming ever more pronounced in the Eurozone where the ECB has in effect moved from a policy of targeting spreads to targeting nominal bond yields in what can best be described as closet yield curve control.  The ECB’s ownership of outstanding Eurozone government securities has risen from 2.3% at the start of 2015 to 38.4% at the end of August 2021.

ECB Holdings of Eurozone Government Securities

Note: Include ECB purchases of government bonds under the PSPP and PEPP and other holdings of government securities. Source: ECB

The trend in the Eurozone is even more notable than in Japan given that the ECB only began formally buying government bonds in 2015 under its Public Sector Purchase Programme (PSPP), which is part of the broader Asset Purchase Programme (APP).

As for the Federal Reserve, it remains comparatively orthodox by the extreme standards of Japan and the Eurozone.

But the trend is, undoubtedly, towards a growing ownership of the Treasury bond market by the American central bank.

The Federal Reserve’s ownership of US Treasury securities has risen from 6% in 1Q09 to 22.5% in 2Q21.

Federal Reserve ownership of US Treasury securities

Source: Federal Reserve

The above three charts capture the direction of travel in what could be termed stealth monetisation or the slippery slope to financial repression.

This secular trend means this writer no longer wants to own government bonds in the G7 world, a view adopted here after observing the manic policy response to the pandemic in the G7 world in the spring of 2020.

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Still, there is no doubt that the Treasury bond market can have a powerful rally from current levels if, say, a vaccine-resistant variant suddenly appears on the scene.

Meanwhile, the obvious risk to bondholders represented by central banks’ growing ownership of government bonds, in the context of ongoing hyper monetary and fiscal stimulus, is to an extent camouflaged by the fact that so many of the leveraged carry trade participants in the fixed income market are trading spreads not levels.

This is a reminder that most of the time in the fixed income world only basis points matter.

But every now and then percentage points matter at which point, as the track record since the Long Term Capital Management (LTCM) debacle in 1998 demonstrates, the leveraged participants expect, correctly, to be bailed out thereby further re-enforcing their faith in leveraged carry trades.

Algorithmic Trading is Making Bond Market Distortions Worse

Meanwhile, in recent years there has also been the growth of another phenomenon which has further accentuated the above distortion.

That is the growing popularity of algo trading.

The geeks executing such strategies have zero interest in macroeconomics.

Rather the algo approach is based on mathematical models centred on three parameters; namely momentum, volatility and carry.

The interesting “big picture” point on the above is that the models, like the risk parity trade, assume continuing negative correlation between government bonds and equities, which is why there will be absolute carnage in the markets if equities and government bond prices ever go down in price together for an extended period.

This will only happen if inflation really returns on a sustained basis.

Meanwhile, it was interesting to see a Bloomberg interview with former Richmond Fed president Jeffrey Lacker in late August, a frequent dissenter during his 13 years as the head of the regional bank and a FOMC participant where he was a voting member every three years (see Bloomberg article: “Ex-Fed Official Lacker Warns Powell in ‘Tough Spot’ on Inflation”, 30 August 2021).

Lacker’s key point was that the Fed is risking inflation getting out of control and that Fed chairman Jerome Powell’s reassurance about inflation being transitory failed to mention that it would “require traumatic surgery” if Powell and his colleagues proved to be wrong.

Lacker based his comments on the experience of the early 1980s. Still, this writer’s view is that, in the event of such an outcome, there is no way the current political set up in Washington is going to allow the Fed to act in the way the late and great Paul Volcker did in the late 1970s and early 1980s when he raised the federal funds rate to 20%.

In this respect, full-scale financial repression seems a much more likely outcome than a riot in the government bond market though the US dollar may take the strain.

The views expressed in Chris Wood’s column on Grizzle reflect Chris Wood’s personal opinion only, and they have not been reviewed or endorsed by Jefferies. The information in the column has not been reviewed or verified by Jefferies. None of Jefferies, its affiliates or employees, directors or officers shall have any liability whatsoever in connection with the content published on this website.

The opinions provided in this article are those of the author and do not constitute investment advice. Readers should assume that the author and/or employees of Grizzle hold positions in the company or companies mentioned in the article. For more information, please see our Content Disclaimer.

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Categories: Global Strategy
Christopher Wood: Chris is internationally renowned for his weekly institutional research newsletter GREED & fear. He has correctly identified all major global financial bubbles over the last 3 decades (US sub-prime crisis, Nasdaq technology bubble, Asian financial crisis, and the Japanese financial meltdown). He’s also the author of three highly acclaimed books: Boom and Bust, The Bubble Economy, and The End of Japan Inc. Since May 2019, Chris has been Global Head of Equity Strategy at Jefferies.
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