The dangers of a world where no one can value long-term government bonds
If the supply of government bonds becomes more of a driver of interest rates, financial and economic trade-offs loom much larger than before.
A funny thing happened along the way to the tariff-induced recession that was supposed to send global activity into a tailspin: as the risk of a sudden stop to global trade flows decreased with massive tariffs watered down and put on ice, government bond yields have surged, particularly at the long end.
In fact, the US and Germany, among other major developed market economies, now have 30-year bond yields that are trading above nominal annual economic growth (assuming these measures remain relatively stable from Q1 to Q2). Outside of the recession caused by the pandemic, when activity cratered relative to bond yields, that’s been an extreme rarity since the global financial crisis of 2008.
What I’ve found is that whenever there is a particularly global component to a rise in bond yields, and the move is particularly large at the long end relative to the five-year maturity — which will tend to encompass a lot of your short- to medium-term views on the economic outlook — it is likely a time when traditional valuation techniques have been leading to extremely poor performance (speaking from very painful personal experience).
Nominal growth and bond yields tend to trend in the same direction, at least, and that relationship has become considerably less reliable in the postpandemic world where we’ve seen a generationally high peak in inflation and government budget deficits have been very elevated in the context of a fairly healthy economy.
The lack of a valuation anchor in long-term bonds matters, particularly in the US, where the dominant mortgage product is the 30-year fixed rate.
It’s in situations like these that you hear a lot more about murkier concepts like “term premium” — effectively, the part of a move in yields that we can’t explain by changes in inflation expectations or the outlook for central bank policy rates.
When the old rules of thumb start to fail, there are three options to try to explain what’s going on: call for a structural shift in which new rules will apply, put more emphasis on qualitative and narrative-driven approaches to explain current dynamics, or bet that the old world order will eventually reassert itself.
The two things that are most different this time are so-called cyclically adjusted government deficits and inflation outcomes — two items that are certainly related, but probably not as tightly as some might presume. Factors like “supply of bonds relative to demand” and momentum are assuming more prominence as presumptive causal factors behind why bond yields seemingly climb higher and higher even if the overall trajectory for growth seems to be cooling.
“I think something that became quite clear to me trading long end Yen rates last year is, the valuation anchor is not there in real time,” wrote Jon Turek, founder of JST Advisors. “In the summer of last year, the argument in long end JGBs was, the Lifers will step in at ‘insert level 20bps away.’ They didn’t. And once they didn’t, the market was left without its arbitrary anchor and had to further re-rate. This happened in long end UK as well. I think that is what’s part of the problem in 30y US at the moment.”
The fact that this is not just a US dynamic but a global one implies that the continued US budget deficits pressuring borrowing costs higher — you know, what prompted Moody’s to finally remove the US goverment’s pristine credit rating — are part of, but not all of, the story. As someone who’s spent most of their adult life saying supply of government bonds doesn’t really matter as a key driver of yields for developed market economies that borrow in their own currencies, the story that appears to fit the price action the best right now is that yes, supply does matter. And as Turek observes, this isn’t the first time this dynamic has reared its head in recent years.
Is this akin to watching some reruns of an old show that’s about to disappear from Netflix’s catalog in a few weeks, or a building drumbeat of evidence about a changing world?
“The global signals in long end fixed income continue to suggest a lack of buyers for DM duration. Japan as noted, German fiscal, the UK never recovered post Truss, France, all are having long end issues,” Turek added. “Now for Europe and even Japan, at this point it is less of a technical problem, but still the signal is that there is a lack of buying of long end government paper relative to the immense supply.”
The upshot of a world where “supply matters” is becoming a more consistent feature of the financial market backdrop is that trade-offs matter.
In recent years, we’ve seen sharp rises in bond yields undo a government in the UK, rattle global stock markets, and foster a persistent malaise in US housing activity. On the other hand, a world of smaller government budget deficits (and less supply) is going to be directly growth-negative, potentially somewhat offset by higher activity in rate-sensitive sectors.
When it’s not so easy to value government bonds as yields are rising, it’s not so easy to imagine free lunches for financial markets and the real economy.
As someone whose most favorite perk in life is a free lunch, I’ve got to say... dang, that sucks.
