The Seeds of the Next Crisis
The latest U.S. inflation number was 3.2% and U.S. Treasuries are once again offering a positive real yield. Most investors are increasing fixed income allocations, albeit from very low levels. Should pension funds, who have long-term liabilities, take the positive real yields on offer today or wait for higher ones? In this article I argue that bond yields will go higher because they already contain the seeds of the next financial crisis.
I look at three influences on bond markets in turn, with a focus on the United States: supply and demand; their role as collateral within the financial system; and the tools left to central banks to mitigate a financial crisis. I lean on the analysis of my friends at CrossBorder Capital, who as ever provide perceptive and original insights. As a recent example, they were among the first to question the consensus that a global recession in 2023 was inevitable. They were yet again right. But the views expressed in this article are Linchpin’s.
Supply and demand is perhaps the easiest of the three to understand. The Federal Reserve has to finance around US$2.2 trillion in the next 12 months. Roughly one third of that will be via long term coupon-bearing Treasuries and two thirds by short-term Treasury bills. However, bills will represent 80% of net new issuance (i.e., not counting refinancing of maturing Treasuries).
Further ahead the U.S. fiscal situation is steadily deteriorating, a fact reflected in the recent Fitch downgrade from AAA to AA+. Defence spending will reach 5%, the interest bill is rising – largely because of the increasing reliance on short-term financing – and the COVID chicken of increased spending commitments is coming home to roost. Tax revenues are failing to keep pace, and CrossBorder estimates that the U.S. public debt to GDP ratio will double from 100% to 200% over the next 20 years. Without some form of financial repression, it seems unlikely that there will be sufficient demand at current bond yield levels (4.5% for the 10-year tenor) to finance this, another reason why the Fed is turning to shorter term instruments.
Let me next turn to the role of U.S. Treasuries and other ‘safe haven’ assets in providing collateral. I have regularly written about the importance of term premia – i.e., the premia which investors require in return for taking duration risk, and they are now close to all-time lows. That can be seen in the inverted yield curve – indeed CrossBorder argue that the downward slope is entirely due to the extreme low levels of term premia and that without this the yield curve is still upward sloping.
In a perfectly efficient market where the U.S. Treasury is indeed the ‘safe haven’ asset, the term premium would be zero, as investors would instantly arbitrage any difference away. However, the term premium on U.S. bonds today is currently -1.5% and has been falling steadily since a peak of about +1.5% just after the Global Financial Crisis.
Behind the fall in the term premium lies financial repression. Institutions have been forced to buy long duration ‘safe haven’ assets as collateral and for capital adequacy reasons, regardless of yield. It is this forced buying which sent Treasury yields to a low of 0.5% in July 2020, and which explains why term premia today are so low and the yield curve inverted.
The demand for collateral is because the reverse repo markets now form a vital part of the U.S. financial system for corporates (not all, of course) who rely on debt finance. The key point to note is that the rise in yields means the value of that collateral pool has collapsed. This was the prime reason for the failure of Silicon Valley Bank and also the U.K. LDI crisis in 2022. Both those events clearly show how sensitive central banks are to this issue.
In summary, the U.S. Federal Reserve has to find a way to finance the U.S. Government’ increasing deficit. However, it cannot allow bond yields to rise too far because the effect on the value of the collateral pool would be devastating. In consequence it is no surprise that they are leaning more heavily on short-term financing rather than long duration Treasuries.
Will these tools mitigate a crisis in the future? Here I come on to the third theme of the article. This reliance on short-term financing is no more than another form of QE: after the GFC, central banks issued bonds and bought them back using short-term financing. All the Federal Reserve is doing now is cutting out the first two stages.
The Bank of Japan has been using Yield Curve Control to keep the bond yield curve down. It has done this to extricate Japan from its 30 years of deflation. With inflation at 3% now it could probably declare it a success. However, this policy has been at the cost of a bitter tussle with market speculators, as I wrote earlier in the year.* The move in July to extend the upper band of 10-year JGB yields to 1% from 0.5% can be seen either as the first measured step in exiting this policy, or alternatively as the Bank of Japan being unable to hold the Yield Curve Control line and forced backwards.
The Federal Reserve today is operating, if not as overtly, in a similar way to the Bank of Japan in using the shape of its balance sheet to try and keep coupon-bearing bond yields down. So it is highly relevant to all investors whether or not the Bank of Japan is able to hold their line. If they can, expect the Fed. and other central banks to preserve at least some semblance of control over markets. If they cannot, bond yields will go much higher.
The seeds of the next crisis are being sown. Supply and demand fundamentals make it unlikely that private investors will buy bonds in sufficient size at the current level. Financial repression may keep term premia low, but in its absence they need to rise by up to 1.5% just to regain a neutral level.
In the short-term CrossBorder’s analysis suggests that U.S. bond yields should rise by about 100bps. However, this is enough to have a substantial further impact on the value of the pool of collateral, and it is likely that the Federal Reserve will have to reach for the QE lever in size once again. They have few other options, whether their aim is to finance the public deficit or to stop bond yields leaping.
For investors the combination of normalised interest rates, rising bond yields and substantial QE is uncomfortable, especially if inflation remains sticky. It must lead to higher inflation and currency devaluation in the longer term, but if the lesson of 2009-2020 remains valid, perhaps not in the short term. Duration is not desirable, at least at current asset prices. Equity valuations will be affected by higher bond yields, and credit markets are vulnerable to a shortage of collateral.
The answer may prove to be that rather unfashionable investment tool, timing the markets and being prepared to take advantage of opportunities. But that requires liquidity and flexibility, something in shorter supply among many pension funds.
* Why the Japanese Market is Important to us all – copyright Linchpin, March 2023 here.