The Great Global Sovereign Bond Shortage

Expectations of economists and pundits notwithstanding, interest rates are falling around the world. Despite the end of quantitative easing in the U.S., and the possibility that the Federal Reserve will raise rates later this year, the long-feared economy-killing yield spike has yet to appear.

During the past few months, I have been discussing this with participants in the bond markets and getting a variety of responses. The one I come back to is surprisingly simple: Increased demand for quality long-term bonds combined with a limited supply has created ashortage of investment-grade securities.

This shortage is why several bond-market observers such as Jeff Gundlach and Gary Shilling expect rates to stay low.

As soon as you wrap your head around this, the first thing you encounter is the massive amount of debt the world over. Most of it is pretty low quality. If you are talking about high-quality debt, it isn’t going to be Greek or Russian or Argentinian debt; it isn’t even going to be Italian or French debt. It will be bonds issued by the U.S., Germany or Japan. That’s pretty much it for the high quality, sovereign bonds offered in any real size.

We can certainly find high-quality paper from Switzerland or Singapore or Sweden or even Taiwan (Norway is rated AAA, but it runs a surplus). Throw in Canada, Finland, Australia and the Netherlands and you have pretty much covered the universe of other A-rated countries, though none of them issues a whole lot of debt. Hence, although there may be no shortage of quality issuers, there seems to be a shortage of quality sovereign securities. I understand that might be hard to imagine given all of the debt worldwide, but the key word is quality. There’s lots and lots of bad paper, but surprisingly limited quantities of good paper.

Before you collectively start ranting about QE, we already know that the Fed has been a buyer of U.S. debt for more than five years. Not too long ago, the Bank of Japan joined in with its version of QE. Now, the European Central Bank is in the game as well. But central-bank buying doesn’t account for the shortage of debt that explains the negative yields we see in parts of Europe.

My back-of-the-envelope calculation (that’s the technical term for a fair guess) is that demand exceeds supply by as much as $1 trillion to $2 trillion a year. That is what has been forcing bond prices higher, and driving negative yields.

There are other forces that account for the dearth of debt. The three biggest are:

Market rally rebalancing: Many traditional portfolios made up of 60 percent stocks and 40 percent bonds — often managed by large pension funds, institutions and other asset allocators — follow a simple approach to rebalancing. As equities rise in price, these investors sell some stock and buy bonds to re-establish the original asset weightings. The 200-plus percent rally in the Standard & Poor’s 500 Index since March 2009 is thus a large driver of bond purchases.

Demographics: Those born in the decade after World War II now are between the ages of 60 and 70. The portfolios of retired baby boomers or those who are approaching retirement reflect a more conservative investment posture. As a group, they have been holding more Treasuries and less stock. This very large cohort is yet another source of demand for fixed-income securities.

Lack of new issuance: On the supply side, we are not seeing the usual pattern that follows U.S. recessions. Typically during an economic slowdown there is a surge of stimulus spending, financed by issuing debt. We saw that in 1990-91 and 2001. The pattern was broken this go around. The Great Recession was especially hard on regional economies, forcing state and local governments to absorb enormous spending cuts and reduce their headcounts. Congressional incompetence and intransigence thwarted much of the usual post-recession federal spending and debt issuance.

Thus, the usual big stimulus projects were mostly absent in this cycle. Add to that the winding down of the wars in Iraq and Afghanistan and the reduction in military spending. President Barack Obama, stymied by Congress, was never able to match the government spending increases of his predecessors to help the economy recover from recession.

Had this economic cycle been similar to 2001, unemployment might already be lower than 5 percent and gross domestic product growth could be a half-percentage point higher — and there would be a lot more U.S. debt issued.

Given how low rates are, and the abysmal state of infrastructure in the U.S., now would be a good time for the nation to increase its borrowing — including issuing 50 year bonds to lock in low rates and pay for the big projects the country needs.

Odd as it might sound, if we want to see rates at normal historical levels, the U.S. should be issuing more — not less — debt.


Originally published here



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    • VennData commented on Mar 17

      Apple will create a product to get us over bridges. Or make going over bridges obsolete. Or force all the bridges into on central location where they’re easier to access.

  1. bigsteve commented on Mar 17

    This article and I read it all on Bloomberg explains something that has puzzled me for awhile. Recently management at my company where I worked changed the way colas are paid out for pensions. It is being prepaid and will be based on how well the investment fund for colas have done year by year. The better the outcome the better the adjustment. If things go to sh*t then no cola that year. Before it was ad hock based on adjustments given to employees and not a vested right. Now it is. New employees are not in the pension. If interest rates stay low we will have low inflation for years and years so traditional colas will be muted. I work for some smart people and they keep teaching me even when I am close to retirement.

  2. wally commented on Mar 17

    It’s an interesting situation: the more governments refuse to borrow, the better borrowing becomes for them.
    Underlying this reluctance is a disturbing truth: governments worldwide have no faith in the future or in their people. They think investment is not worthwhile.

    • DeDude commented on Mar 18

      No its actually the other way around. A substantial % of “their people” have no faith in their government. They are to stupid, to lazy or to distracted to understand what government is, what it does and why it needs to tax them. So they will vote for any politician that promise to lower taxes and against any that say we need to increase them.

  3. Blissex commented on Mar 17

    «the first thing you encounter is the massive amount of debt the world over. Most of it is pretty low quality.»

    That relates to negative interest rates… When someone lends money to a state or a company at negative interest rates that’s no longer a loan, it only makes sense if the “lender” actually considers the negative interest a safekeeping fee, as if the “borrower” were leasing them a strongbox.

    A lot of insiders are thus willing to pay what is in effect a custodianship fee to those they reckon can be relied on to return their money… That only makes sense if they expect any borrower offering positive interest rates to be essentially insolvent, either already or soon. See Greece of course.

    The conclusion I draw is that a lot of wealthy insiders seem to be sure that there are huge hidden capital losses ready to blowup the opaque balance sheets of a lot of borrowers, and since they don’t know exactly how these huge capital losses are distributed, they are paying custodianship fees disguised as negative interest rates to a small minority of “borrowers” whose balance sheets are transparent and clearly solvent.

    Put another way, accounting and statistical standards have been relaxed so much, especially after the 2007-2008 crisis, in a “Japanese” way, to “extend and pretend” to cover widespread hidden insolvencies, that many important market participants don’t know where to deposit their money except to unimpeachable custodians.

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