A four-decade bull run in developed-market government bonds has come to an end — leaving traders to deal with the impact of huge planned bond sales by central banks into volatile markets.
Yields on government bonds in major markets have soared this year, as investors reacted to higher-than-expected inflation, sharp interest rate hikes, and the looming unwinding of trillions of dollars of central bank bond-buying carried out since the financial crisis.
According to Deutsche Bank strategist Jim Reid, at a global market level, government bonds are now in their first bear market for more than 70 years. The yield on 10-year UD Treasuries has risen from less than 1.5 per cent to around 3.8 per cent this year. Yields rise as prices fall.
As many central banks rapidly tighten monetary policy, the US Federal Reserve is stepping up the pace by winding down its nearly $9tn balance sheet, which was built up through years of quantitative easing stimulus. It plans to shrink it by $95bn a month. The European Central Bank has also been discussing shrinking its €5tn bond portfolio.
The likely impact on bond markets from these looming bond sales is unclear. However, with markets already under pressure from interest rate rises — which have created large price swings in these previously stable assets — there are fears that the additional supply of bonds could suck cash out of the system and make trading even more difficult.
Quantitative tightening is “very clearly a constant cloud”, says Ritchie Tuazon, fixed income portfolio manager at Capital Group — although he adds that, given how well quantitative tightening has been flagged to investors by central banks in advance, it is “hard for me not to believe it was already in the price”.
Even so, he believes the planned selling could make trading harder. “It’s adding to volatility,” he says. “It makes liquidity a little bit poorer.”
Liquidity in the the US Treasuries market has fallen to its lowest level since spring 2020, when markets were in turmoil at the onset of the coronavirus pandemic, according to JPMorgan data.
Recent turmoil in the UK gilts market, sparked by former chancellor Kwasi Kwarteng’s announcement of unfunded tax cuts in September, has only added to concerns about the fragility of bond markets, generally.
With the volume of gilts that must be absorbed by investors already set to rise sharply due to UK government borrowing, plus the replacement of quantitative easing with quantitative tightening, “it is not surprising” that Kwarteng’s announcement “caused a great deal of nervousness”, says Peter Sleep, senior investment manager at Seven Investment Management.
The ensuing volatility, and fears that forced selling by pension funds could create a downward spiral, forced the Bank of England to intervene in markets with the purchase of up to £5bn of bonds a day.
That meant a delay to the bank’s planned quantitative tightening — or bond selling — programme. It had been the buyer of 57 per cent of bonds issued by the UK government between March 2009 and June this year, according to Bank of America.
Following the BoE’s intervention, a change of chancellor and the reversal of most of the planned UK tax cuts, gilt yields fell, although as of Thursday, when prime minister Liz Truss resigned, they remained above where they were before Kwarteng’s “mini” Budget.
The UK turmoil spread into US and European bond markets, with the yield on the 10-year Treasury posting its biggest one-day rally since March 2020 — even prompting speculation among some in the market that the Federal Reserve could follow suit and pause quantitative tightening.
“QT will make this worse,” says one senior hedge fund executive, echoing the fears of a number of investors.
Investors are already having to take action to protect themselves against a lack of buyers or sellers and the higher cost of carrying out a trade.
“It’s causing us to trade less,” says Tuazon. “We’re still in the markets every day. But, as the bid-offer [spread] widens out, the bar to trade gets higher.” That means the expected return on a position needs to be higher for him to invest, although market volatility means bond prices can move further, which could improve returns on a position.
“The anticipation of QT is why you’re seeing concerns about liquidity,” says Pilar Gomez-Bravo, director of fixed income for Europe at MFS Investment Management, adding that volatility in the gilts market means the threshold for putting on a trade has risen. “You’re having to rely on long-only investors to buy bonds [during QT]. That paints a really tough picture going into year-end.”
It remains to be seen how determined policymakers are to stay the course on quantitative tightening in the face of market volatility. The Bank of England has ended its temporary bond-buying programme although a new short-term lending facility is set to continue until November.
Nevertheless, some investors see benefits from the bond sales and the slow reduction in central banks’ influence on markets.
Tatjana Greil-Castro, head of public markets at Muzinich & Co, points to the potential for better price discovery in markets such as German Bunds, where there has long been a shortage of securities to trade.
“There [are] not sufficient Bunds in circulation to have a well-functioning repo market,” she says. As bonds are sold, “there will be more free float . . . This would mean the actual Bund yields would more closely reflect fair value.”