If you’re wondering why 2022 is set to be the worst year for global bonds in modern history, “it’s the supply, stupid!”
It’s actually a lot more than that, but I like the quote. It’s from BofA’s Michael Hartnett, whose penchant for producing quotables is legend.
Certainly, supply is a factor. And as we learned the hard way during Liz Truss’s fraught six weeks as UK prime minister, the tension between central banks’ nascent efforts to trim their balance sheets and increased issuance to fund fiscal initiatives can result in turmoil. Chaos, even.
The figure (below) gives you some context for what’s being foisted upon private investors, who’ve been asked to absorb a lot of supply.
Price discovery is now playing a role, as the price insensitive buyer steps away.
Do note: The “vigilante” narrative depends on one’s perspective, though. As Stephanie Kelton alluded to Friday, if you captured the vigilantes and unmasked them, it’s not clear whether you’d be left staring at bond traders determined to impose fiscal discipline, or just central bankers who are no longer supporting the market.
Whatever the case, BofA called the net supply outlook for 2023 shown in the figure (above) a “very conservative forecast.” The concern, obviously, is that markets won’t absorb all of this with anything like alacrity, and that central banks will be compelled to choose between moving ahead with QT and the preservation of market functioning.
If the Bank of England’s recent return to bond-buying in the face of a disorderly rise in long-dated gilt yields was any indication, policymakers will subjugate the inflation fight (as manifested in QT plans) to financial stability (as proxied by orderly trading in sovereign debt).
Needless to say, there are pressing concerns about Treasury market functioning. Janet Yellen weighed in earlier this month, and talks of a Treasury buyback plan have gathered momentum. Bloomberg’s Alex Harris published a kind of CliffsNotes explainer on Friday which is worth bookmarking for future reference.
“Liquidity metrics are flashing at crisis levels, making the debt market that’s a key underpinning of global financial markets potentially so fragile that another shock could impair its functioning,” Harris wrote. “That’s why for the first time in more than two decades, the Treasury is considering buying back its bonds as a way of stabilizing the situation and buying time for policymakers to find more permanent solutions.”
Every day someone else sounds the alarm. On Thursday, it was BofA’s Mark Cabana and Ralph Axel. Cabana is a pretty big name as far as sell-side rates strategists go. He got a lot of attention in the fall of 2019 when the Fed was busy putting out fires in the repo market.
“Market liquidity has deteriorated with elevated global macroeconomic uncertainty. This is especially true in the US Treasury market,” Cabana wrote. The bank “agrees” with Yellen that there are potential problems. The figure (below) illustrates the scope of what I think it’s fair to describe as a burgeoning mini-crisis.
“The liquidity drop is due to acute macro uncertainty, elevated debt, tight regulations and some prior UST debt management decisions,” Cabana said, exhorting policymakers to find a solution. “The UST market needs tending to retain depth and liquidity. Liquidity is a privilege, not a right,” he added.
Buybacks and SLR reform are options. “The slower the adoption, the greater risk of a UST functioning breakdown,” BofA warned.
Remember: The US Treasury market is (famously) the deepest and most liquid market in the world. If market functioning breaks down there, everything else (inflation included) is of secondary importance.
Although not BofA’s base case, a “breakdown” is a “building tail risk,” Cabana warned, describing the Treasury market as “potentially one shock away from functioning challenges.”
If you’re wondering what might be the “one shock,” Cabana tossed out a few candidates, including large-scale forced selling, de-leveraging from risk parity, outflows from mutual funds, selling by reserve managers (e.g., to raise USD cash and/or defend their currencies) and a basis unwind in hedge fund RV trades (that should sound familiar to some readers).
It’s also possible that an external event could serve as the catalyst. In that regard, BofA mentioned tweaks to the Bank of Japan’s YCC regime or a “surprise” Democratic sweep in the midterms, which would have implications for fiscal policy in the US.
Looking a polls today I think we can probably write out a surprise Dem sweep from the list of potential shocks to the treasury market. It is increasingly clear there is some stress, I have not seen bid-ask spreads this wide for long term bond trades since the Covid panic, the long end has been hammered relentlessly the last couple of weeks.