We have seen an enormous amount of volatility within the bond market recently, inflicting fear onto investors who were preparing for a steady recovery from the pandemic. Most have taken it as a given that we will soon be able to return to normal with the rapid rollout of vaccines across the world, but as this moment comes closer, the possibility of much higher inflation that could push rates upwards is worrying firms that have built their business models and plans around the current near-zero rates. There will be many opportunities to emerge from these fluctuations and potential dips, but confidence in the resulting post-COVID world is needed to help us return to the true ‘normal’.
The debt market
To recap, government bonds are a form of debt issued by the state to raise funds for government spending or investment, and play a large role in the financial system due to the magnitude of the money at stake. When a bond is purchased, income payments are received as compensation for the given debt, the return relative to the price being known as the yield, which moves inversely to price.
Since 2008, bonds have been seen as a pretty steady source of income with little risk or reward. The lack of inflation and low interest rates across the developed world has kept yields on bonds fairly low as the opportunity cost of holding them remained small. We have seen plenty of issuances during this time, with the US market alone worth over $21trn today, but for most of us, the bond market has stayed off our radar compared to more traditional equities.
Last week, we saw a large increase in bond yields as prices fell. We began the year with around a 1.1% yield on the US 10-year bond, one of the main indicators of the market, which last week rose to 1.6% in total. The rate fell back to 1.42% on Wednesday, but increased back to 1.56% just two days later, leading to a huge shock in investor confidence. We have begun to see the consequences of this, with Thursday’s auction for 7-year bonds having the worst turnout for demand in a decade, which led to 40% of bonds having to be taken by primary dealers (a sign that the market’s appetite has fallen dramatically). Currently we see no signs of this volatility calming down, so we will have to wait before we can make a judgment about the resultant sentiment taken.
Why have we seen this?
One of the primary reasons for increasing yields is that investors are beginning to price in the possibility of large increases in future inflation. On Friday, we saw the passing of Biden’s $1.9trn stimulus package, which, though it may be key for pushing growth upwards, could do the same for inflation. The five-year break rate, a measure of investors’ medium term inflation expectations, has hit 2.5% today for the first time since 2008, suggesting we are entering a changing paradigm of price levels. As for the Fed, there is very little they can do having exhausted most of their traditional monetary policy arsenal, with rates promised to stay at current levels till 2023 and quantitative easing at near capacity. Still though, even the possibility of hiked rates in 2023 is a concern to investors who are trying to work out where markets will be moving to.
In the international community, some central banks tried to calm down markets with action. Australia is arguably the most prominent example: it doubled the size of its regular bond purchases last Monday, to an additional $3.1bn, which did appear to offer some reassurance. The UK on the other hand was closer to the US with heavy stimulus spending in the most recent budget, but the Bank of England remained much quieter as the magnitude of the shock wasn’t as severe. This has been another real test of what central banks are prioritising, whether they prioritise their mandate of price stability or maintaining output.
Regulation and reform
Another contributing factor is the sudden changes in banking regulation as we begin to leave the pandemic. During the onset of last year’s recession, several concessions were made due to the immense pressures from this unprecedented challenge, importantly to the Supplementary Leverage Ratio. This is the measure of how much capital a bank is required to have in proportion to its assets, which currently stands at somewhere between 3-5%. The changes made meant that cash and government bonds did not count towards a bank’s total assets, and therefore the required reserve was less, allowing them to increase borrowing rather than keeping cash on hand for emergencies.
The issue of how long these changes should be kept for has become much more political, with prominent Democrats pushing for the changes to be removed, bringing regulations back to normal, while Republicans argue that it is too early to be able to put the banks back under such pressure. Elizabeth Warren believes that the banks are attempting to weaken the framework that was put in place after the 2008 Global Financial Crisis, so to convince her they will need to show the importance of these funds and justify the share buybacks and high dividends that have been seen.
COVID exit opportunities
This dip is still nowhere near the peak of last year’s crash in March, but it still demonstrates the uncertainty that the market is facing as investors are working out what a world free from the pandemic will look like. The optimism seen in the stock market is spreading to bonds, as the likes of PIMCO have estimated that we could see growth levels of over 7%. There are also forces that will of course counteract this and present a new threat to markets, such as ageing demographics and environmental issues, but the general sentiment appears to be putting a much bigger emphasis on this near term growth. The Fed may have to take up a more aggressive policy to ease markets if things get out of hand, but if managed correctly, we can expect the next few years to be prosperous, full of growth, and to continue pushing the standard of living back up for many.