If you’ve kept up with the news at all in the last few weeks, you’ll have noticed that bond markets and bond yields are suddenly in the spotlight. This is due to a number of factors. On the one hand, the ECB recently published the minutes from its last meeting, held in December, which revealed that it may actually start phasing out its current bond-buying program a bit earlier than expected. The market had assumed that the program would go on until September, and so if it ends sooner, that could significantly affect the European bond market. In Japan, the markets also suffered some turbulence in response to the upcoming monetary policy, euphemistically termed ‘stealth tapering’, which for now, I’d take to mean ‘secretly doing less bond-buying’. The third factor was that Bill Gross, considered the supreme authority on bonds, announced that now, the 30-year bond bull market really had come to an end. No one seemed to care that when he made the very same announcement only a couple of years earlier, he turned out to be wrong. The Wall Street Journal, the Financial Times (weekend special!), the Economist: all the serious media printed articles exploring the possibility of there being a new bond bear market on the horizon.
The idea got a lot of attention, but didn’t actually lead to much real action. Since the beginning of the year, the German, US and Japanese bond yields have risen no more than − brace yourself − 0.18%, 0.19% and 0.04%, respectively. I guess it depends on your definition of a bear market…
So is it a storm in a very small teacup? When you look at this week’s graph, there actually does seem to be more going on than meets the eye. The graph was created by Torsten Slok, Chief International Economist of Deutsche Bank, who has several interesting graphs to his name. What it shows are changes in the supply of US fixed income to be sold over the next few years. In other words, the amount of debt that will have to be funded, broken down by source. For example, the two gray bars show the government deficit to be funded. Thanks to Trump’s new tax plans, government spending is expected to rise more sharply than income and the resulting deficit can only be covered by issuing more debt. The black area then shows the increase in bonds coming to the market linked to Fed policy. As announced last year, the Fed will gradually scale back its large holding of Treasuries over the next several years. Not by selling them directly, but by not reinvesting all funds that become available. Strictly speaking, this will not increase the outstanding amount of bonds, but it does mean that, slowly but surely, other market parties will have to absorb more bonds. Last but not least, the two blue bars show the amount of corporate bonds that will mature over the next few years and will probably have to be refinanced. Combined, we will be facing a debt of USD 1000 billion in 2017 and double that amount in 2019, that needs funding. So based on this graph, it’s not so strange that everyone’s suddenly talking about a bear market.
Now don’t get me wrong − I really do like this graph. But as usual, just as everyone has come to expect of me, I have some reservations. The key thing to point out is that the graph lumps apples and oranges together in the same category. The blue bars show how much the corporate debt will mature over the next few years, while the gray and black bars show the new debt to be absorbed by the market, the net increase. The reason why this is done is easy to understand. If they had also looked at the maturing portion of the government bonds, then the black and gray bars would have been much larger and there would be no doubling in the demand for funding, either. You could of course say that the corporate debt (shown in blue) will have to be refinanced and therefore will also have to be absorbed by the market, but when a bond matures, it also means that an investor suddenly has a pile of money that needs to be reinvested. It’s pretty likely that part (or maybe even all) of it will be reinvested in corporate bonds, which would make the blue bars a lot less scary than they appear in this graph. In other words: either the gray-black bars should be a lot higher (leading to a smaller relative increase of the debt problem), or the blue bars should be a lot lower (although no one knows how much the net increase of corporate bonds will be).
This brings us to the second point: these are forecasts, which depend in part upon the underlying growth. If the economy grows faster, government income will rise more rapidly (more tax revenue), while spending will actually be lower than expected (unemployment benefits), resulting in a smaller deficit. This was also the argument used by Trump to get his tax plans approved: the tax cuts would end up paying for themselves. While I’ll admit that I’ve met very few economists who agreed with that statement, it could actually be correct. The same goes for business: how much more debt is issued will depend in part on economic prospects, profitability, interest rates, etc., etc.
Which brings me to my last point: none of this is new information. We know that expectations play a big role in the financial markets and that they tend to act in anticipation of, rather than in response to, economic developments. The Fed policy was already announced halfway through last year and Trump’s tax plans in December, so we can’t say that any of this is news to us. Now, it could be that bond markets don’t yet realize its significance (what I think), but there are also investors who believe this news has indeed already been priced in. In their view, the fact that bond yields have hardly risen is because there’s such a huge pile of money waiting to go into (safe) investments, that yields have not caught up.
As I said, while I do think we should expect to see bond yields rise over the next year, I still have some doubts about the outrageous rumors that a new bear market is brewing because so far, the bond market has hardly moved.