The coming tsunami of government bonds
One of the few certainties in investment at present is that there will be no shortage of government bonds in the coming years. Government debt continues to rise and, per the latest International Monetary Fund (IMF) projections for the G7, will hit 110 percent of gross domestic profit by the end of 2012, before rising further in 2013. One has to go back to the aftermath of World War II to find a similar level of debt in the advanced economies (see Chart 1).
Such an outlook has led to fears that government bond yields will rise sharply in coming years as investors struggle to digest increased issuance. Such fears are compounded by (i) evidence that China has slowed its rate of buying US Treasury bonds, and (ii) looking ahead, real concern over what happens when quantitative easing (QE) comes to an end and the Federal Reserve (Fed), and others, stop adding to their balance sheets.
‘Financial repression’, where institutions are required to hold government assets at unattractive prices for ‘regulatory reasons’, is a tool that the authorities might well resort to in an attempt to meet their funding needs.
How much issuance do investors have to soak up?
We use IMF forecasts of the US fiscal deficit as our baseline level of net issuance over the next six years, and assume that the Fed neither adds nor subtracts from its stock of holdings over this period. On this basis, a simple summation gives a total of $5.6 trillion (37 percent of 2011 GDP) for total government borrowing, which we use as an estimate of net issuance in nominal terms (see Chart 2). Total issuance will be higher, however, as the government also has to roll over maturing debt. And of course, if the Fed unwinds QE and sells US Treasury bonds back into the market, the supply of bonds will be greater. For example, if they sell around $1 trillion, we would see issuance of more than $6 trillion in the next six years, approximately 40 percent of 2011 GDP.
Cutting the budget deficit in the US would, of course, be the preferred means by which to reduce this upcoming wall of issuance. The Congressional Budget Office (CBO), for instance, estimates thatthe cumulative deficit from 2012 to 2017 will be less than $3 trillion, but recent history suggests that these estimates tend to be overly optimistic. Moreover, the political debate in the US seems to be more focused on the size and role of government rather than cutting the budget deficit. We are therefore content to use the IMF projections as our baseline scenario, though appreciate that an improved fiscal outlook in the medium term would temper the issues we raise.
Funding the US government: the Fed has picked up from Asia
There has been a significant shift in funding sources over the past five years, with a fall in purchases by the external sector (primarily Asian central banks), as the financial crisis has led many official investors to seek to diversify their foreign exchange holdings away from the US. The slack has been largely picked up by the Fed, which has swung from being a net seller in 2007 to the biggest buyer of US Treasury bonds in 2011 as the QE programme kicked in. There have been modest increases in purchases by banks, institutional investors and holders of money market funds.The external sector remains the biggest holder of US Treasury bonds: although its share of outstanding debt has fallen from 49 percent to 45 percent, it is well ahead of the Fed at 15 percent (see Chart 4). Within the external sector, we have seen China overtake Japan as the largest holder of Treasuries since 2007, aided by a series of large current account surpluses.
The Impact of deleveraging
Among the other sectors we have seen increases from banks and brokers as well as the household and non-financial corporate sector. This reflects the impact of deleveraging where households and corporations cut back on their borrowing, thus resulting in an increase in deposits relative to loans in the banking sector. In response, banks have been putting their excess reserves into US Treasury bonds.
In addition, increased risk-aversion has led the household and corporate sectors to put more of their money in government bonds at the expense of investment in the real economy and financial assets such as equities. Under pressure from regulators and shareholders, banks are also de-risking. Meanwhile, US state and local governments have been under acute financial pressure and have reduced their share from 11 percent to 4 percent.
The future shape of the market
Returning to our baseline scenario of just over $5.5 trillion issuance to 2017, how are the different buyers likely to respond?
As a starting point, we assume that the Fed’s stock of US Treasury holdings is the same at the end of this period as currently, thus meaning that the Fed purchases none (in net terms) of this issuance. Few should be surprised by this as QE is seen as a temporary measure; this assumption, however, removes a major buyer from the market, placing the burden of issuance more heavily on other sectors.
As seen above, the external sector is currently the biggest holder of US Treasuries and we would expect it to remain so in 2017. However, the decline in the sector’s share of the US Treasury market is also expected to continue as a result of lower trade surpluses and consequently a reduction in the need for official foreign exchange intervention by the emerging world, particularly China.
Using IMF forecasts we calculate the cumulative current account surplus for the next six years from the main countries involved in US Treasury purchases. We then adjust this figure to reflect the rate at which surpluses are likely to be converted into US Treasury purchases to give an estimated $1.8 trillion of US Treasury purchases by the external sector between now and 2017. This compares with $2.4 trillion over the last five years.
Can the private sector step up?
With our estimate of the external sector purchasing $1.8 trillion and the Fed purchasing none, this leaves $3.8 trillion to be found from the private sector. Between 2007 and 2012, the latter bought $2.4 trillion, meaning that we need to see a more than 50 percent increase in private sector purchases.
Is this possible without a substantial rise in yields? It is difficult to answer given the range of variables involved. However, what we can do is identify the pressures facing each sector and the scope for greater purchases.
"The temptation for the US government to introduce more demanding restrictions on institutional investors (pension funds and insurance companies) will be great."
For the banks, in addition to the aforementioned effect of private sector de-leveraging, regulatory pressure is building. Following the financial crisis there have been significant moves for banks to become safer, less risky organisations such that they will not need to be bailed out by public funds. Basel III has been designed with this aim in mind and while US banks may not follow this to the letter they are likely to increase their holdings of US Treasuries which are zero-rated for risk purposes. Tighter liquidity requirements are also likely to result in higher holdings of US Treasury bonds as they are the main eligible assets for meeting the new liquidity coverage ratio.
Insurance companies are facing similar pressures to improve their capital and liquidity profiles, which will make government bonds more attractive due to their low or nil capital charge. Life insurers also have a natural demand for long-dated bonds to duration match their liabilities, and government bonds may be used to meet this need.
Although they have not been subject to regulatory scrutiny to the same extent as a result of the crisis, pension funds are also beingincreasingly pushed to face up to their liability matching issues. Longer dated, inflation-linked government securities are often the only asset which can meet these demands.
The scope for financial repression of institutional investors
The temptation for the US government to introduce more demanding restrictions on institutional investors (pension funds and insurance companies) will be great. We estimate that the total value, to the end of March 2012, of assets with institutional investors totalled around $18 trillion, of which around 6 percent was in US Treasury securities.
What if, for example, the authorities required that 15 percent of assets had to be held as US Treasuries? We estimate this would require an acquisition of approximately $1.7 trillion of US Treasuries, a sizeable chunk of the $5.6 trillion issuance we predict between now and 2017. Of course, a more or less punitive regime would have different effects on the scale of purchases needed by institutional investors.
Although it may seem unlikely that the US government would legislate for such an increase in US Treasury holdings, there are other forces pushing institutional investors to move in this direction. One of these is the well-publicised shift in demographics which will gradually increase the need for long-duration assets as the baby boomers move toward retirement.
Safe assets in scarce supply
Less well known is the pressure created by a shortage of safe assets. The financial crisis has reduced the number of assets regarded as safe by turning mortgage and other asset-backed securities toxic. The problem has been made more acute in a global context by the euro crisis which has taken Italian and Spanish bonds out of the pool of safe assets. The result is that institutional investors are finding they often have little choice but to buy government bonds if they wish to find a secure haven for their capital.
The problem has been made worse by QE where the central banks have bought a significant chunk of government bonds. For example, comparing a group of safe assets today with five years ago shows that the pool has shrunk by some $8 trillion, or 20 percent of world GDP (see Table 1).
Pulling this together enables us to estimate how the US will fund itself over the next five years. The external sector will still make the biggest contribution, but we have pension and insurance funds coming in with a similar level of investment at $1.7 billion. Banks, brokers and dealers are forecast to make nearly $1 billion in US Treasury purchases, marking a significant shift in the sector pattern of US Treasury purchases.
In an historical context these figures would adjust market share to a proportion closer to the levels of US Treasury market involvement seen in the 1980s for pension funds and insurance companies. By contrast, banks and brokers would still be well below the levels seen before the1990s when regulation was tighter (see Chart 5). Some might see this as an indication that the requirements on banks could go much further.
Heading for a funding crisis?
These calculations illustrate how the US government might find the funding needed for the next five years. They are only assumptions, but they do show that in the absence of QE and with slower purchases from overseas, a considerable burden will fall on the private sector.
The demand on institutional investors is likely to be considerable. Private sector purchases of US Treasury bonds will need to rise by nearly 60 percent over the next six years. The banks will play a part in this as new regulations push them toward safer assets. Institutional investors meanwhile, might, based upon our calculations, be expected to pick up around 30 percent of the net issuance over the next five years, compared with less than 10 percent in the last five to 2011.
"If the politics remains difficult and the economy is still weak there will be considerable pressure on the Fed to step in and restart QE."
The question from an investor perspective is whether this increase can be achieved without a significant increase in yields. One of the consequences of the financial crisis has been that there is now a shortage of safe, high quality assets. Pre-crisis, investors might have filled their allocation to ‘safe’ assets with private asset-backed securities, or a wide range of European sovereign bonds—today, US Treasury bonds are one of the few safe havens. This is one of the reasons why yields on US Treasuries and UK Gilts have fallen to record lows, even though AAA status has been lost by the former and is under threat in the latter.Yet, even in a world where safe assets are scarce and demographic pressures are pushing investors into the clutches of government bonds, the scale of purchasing required is likely to make pension and insurance fund managers baulk. Therefore, upward pressure on bond yields over the medium term is one of the conclusions from this study. This is not a short-term prediction as monetary policy will keep rates low along the curve, but looking further out, the balance of supply and demand points to higher yields.
Policy options: the lure of financial repression
The question then would be: how do the authorities react? If the economy is recovering then monetary policy may already be tightening and higher real yields would be justified. Stronger growth would help bring down budget deficits, improving the funding equation and leaving the authorities and markets content.
Alternatively, as this analysis indicates the pressure on yields comes through a funding crisis there are several possible courses of action. The preferred option would be for the governments to embrace the message from the market and reduce their budget deficits. In this way, rising yields could be heralded as the return of the bond market vigilantes, pushing politicians to take action by cutting spending or raising taxes.
Overtaken by events
If the politics remains difficult, however, and the economy is still weak then there will be considerable pressure on the Fed to step in and restart QE. This would seem a fairly likely combination. That said, the hostility from sections of the US political scene towards QE remains as strong and vociferous as ever, evidenced by Republican party candidate Mitt Romney’s choice of staunch Fed critic Paul Ryan as his vice presidential running mate.
Printing money to solve a funding crisis is not a sustainable solution over the medium term. Thus, financial repression is likely to be the tool that the US government turns to as it seeks to plug its deficit. One advantage of this tactic is that it appears to be victimless, but savers will be the big losers as they find their investment returns and pensions will fall well short of what is needed to sustain future living standards.
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The views and opinions contained herein are those of Keith Wade, chief economist & strategist, and James Bilson, economist, and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. For professional investors and advisers only. This document is not suitable for retail clients.
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