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The writer is chief economist for Europe at T Rowe Price
Does the supply of bonds affect the level of yields? The answer is emphatically no, according to a popular theory of bond valuation. This argues that long-term interest rates are just the average of future short-term interest rates – which is a good description of the yield curve in normal times. But that is not the state of the world we find ourselves in today.
Demand for sovereign debt from the public sector and regulated entities has been unprecedented over the past decade. Quantitative easing bond-buying programs since the financial crisis to support economies and markets have led central banks to significantly increase their share of domestic public debt. Foreign monetary authorities purchased G7 government bonds as part of their foreign exchange reserves. And demand from banks has increased due to liquidity regulations following the Basel III reforms.
For all these reasons, the private sector has had to absorb only a trickle of sovereign debt issued, even at the height of the Covid-19 pandemic, when a huge increase in public sector deficits was accompanied by a massive increase in QE.
This has significantly distorted the major bond markets. The Bank of Japan owns more than 50 percent of the Japanese government bond market. Only around 20 to 40 percent of the German Bund market is accessible to private investors. One sign of these distortions: 10-year Bund yields fell into negative territory just two years ago.
And because private investors arbitrage yield spreads in G7 bond markets, these distortions have likely driven down yields around the world, even in the least distorted markets. This massive presence of price-insensitive buyers has reduced uncertainty about future return levels. As a result, term premiums collapsed around the world. This is the additional return for investors who take interest rate risk over long periods of time. Such distortions have likely also affected the ability of markets to assess and indicate the R star – the level of interest rates at which monetary policy is ideal to keep the economy at a balanced level: neither too tight nor too flexible.
But these favorable winds have ended. On the demand side, the main central banks are now in quantitative tightening mode: either government securities are actively sold, or maturing bonds are no longer reinvested. At the same time, governments are issuing large amounts of debt due to large deficits.
But this time around, central banks – the price-insensitive buyers – are mostly not present in the market. The private sector must now absorb a significant amount of new sovereign debt. The theory that describes the curve well in normal times says that this should not matter for the level of returns. But returns are determined by the marginal buyer, which will now be the price-sensitive private sector.
In this new world, the supply of bonds can affect the level of yields via term premia. An increase in the bond stock will lead to an increase in the private sector’s share as central banks no longer have a presence in the market. But private sector investors have many other options when it comes to buying bonds. Yields must therefore increase to become more attractive.
For example, primary dealers bought 18 percent of the total amount at a recent 30-year U.S. Treasury auction, compared to an average of 11 percent over the past two years, because other private sector buyers are stayed away. This signal of weak demand led to an immediate rise in US bond yields. This dynamic becomes even more important when all G7 governments simultaneously issue a glut of debt. Private investors then have a much wider choice of products to purchase. To attract them, bonds from countries with the same default risk will have to offer higher yields. This is an important reason for the recent rebound in term premiums.
Expectations of a large future bond supply have similar effects on term premia. In 2022, U.S. government bonds recorded their largest losses since 1871. Due to this and the expectation of a large number of upcoming issuances, investors will be cautious about holding an amount excessive government bonds. This uncertainty regarding the future level of yields, a consequence of the expected increase in issuance, is currently contributing to an increase in term premiums.
In some countries, such as the UK and the US, term premiums have already reached levels not seen before the 2008 financial crisis. However, given the large number of issuances, QT and prudence investors about future yield levels, term premiums could easily increase further from the levels we see today. Governments and investors should be aware that in current circumstances, bond issuance is an important determinant of returns.