When higher debt doesn’t lift yields

The bond market seems to have entered a period of calm after central banks committed to large-scale monetary support in response to the impact of the pandemic on economies. The support took the form of ultra-low rates, large-scale bond purchases and acceptance of a broad universe of collateral for cheap funding.

The European Central Bank has committed to a €1.35 trillion bond-buying programme. The US Federal Reserve (Fed) increased its balance sheet to over $7 trillion and set aside $750bn for corporate bonds. While the Bank of England agreed £200bn of purchases, lifting the overall asset stock to £745bn. It appears that the focus will next shift towards the real economy.

Five essential questions

The five essential questions not only for bond investors, are:

1. Will the economy rebound quickly with the help from the medical front or will a second wave of infections put a recovery at risk?
2. Are companies able, and willing, to keep workers employed once the furlough schemes end, or will a renewed surge in unemployment weaken consumer spending for a longer period?
3. Will a rise in default rates put the bond market and bank balance sheets in distressed situations?
4. Can the bond market cope with the vast debt supply?
5. How might bond market risks be mitigated?

While there are no straightforward answers to the above questions, monitoring key indicators and looking at previous patterns should help. A scenario whereby inflation and yields rise significantly, while the global economy enters a prolonged, and deep, recession that causes large default waves seems the least likely scenario. The result is more likely to be similar to a wedding buffet: a bit of everything.

Economic recovery

China’s economy grew by 3.2% between April and June while US retail sales are, an encouraging, 99% of the levels seen at the start of the year. In addition, Google’s and Apple’s mobility data tracking people’s location suggest that a large part of consumption started to pick up again.

But the risk of a rebound of COVID-19 infections, which puts a full recovery in doubt, is unlikely to disappear soon. Meanwhile, many companies have started to announce large job cuts. In the absence of any positive catalysts (such as a vaccine) on the horizon, more job cuts seem inevitable, leading to a weakened consumer and muted wage growth, putting a cap on inflation.

Default stress

Default rates within speculative grade bonds have already started to rise from the multi-year lows, in the US to 5% while 1.8% in Europe. A rise towards 8% in the US, for example, seems likely considering the pattern seen in past crises. As highlighted in July’s Market Perspectives, and confirmed by second-quarter earnings, banks have set aside large provisions to cover for a deluge of debt defaults. Meanwhile, stress tests suggest that even in severe scenarios capital buffers are ample.

Debt supply in isolation unlikely to lift yields

The wall of anticipated bond supply and the risk of higher interest rates appears to be one of the biggest concerns among investors. Indeed, the US real rate rose in the early 1980s in line with more US debt.

Various studies, like by Thomas Laubach of the Fed in 2003, suggest that a 1% increase in the deficit leads to a rise of 25 basis points in yields, all else being equal.

The challenge is that things are never equal and cyclicality and demand patterns, as well as inflation expectations, are large drivers of rates. Later in the 1980s, bond yields fell when debt rose in subsequent periods. Yields also trended lower while debt rose in the aftermath of the 2008 credit crisis. In fact, the correlation between inflation and debt has been strongly negative in the last 50 years.

Demand patterns

Demand patterns play another important part in the discussion. Since the credit crisis in 2008 the Fed has become a large buyer of treasuries and holds roughly $3 trillion of T-bills and treasuries in its portfolio while buying roughly $80bn a month. The central bank has indicated that it is likely to step up whenever required, meaning that higher debt as a result of a deepening crisis will likely be met by more bond purchases.

A sudden drop in demand by foreign investors, who own roughly 40% of outstanding US debt, seems unlikely. The reason is that it is in foreign banks’ interest to keep the currency low, specifically in a low-growth environment. Meanwhile, banks and pension funds are obliged to buy a large part of the outstanding US debt, given regulatory requirements, to deal with pension deficits and to keep the liquid, high-quality asset portion high.

Will inflation politely decline the Fed’s invitation?

Inflation is likely to stay low for the foreseeable future. The market-implied inflation in five years is still below 2%. Only a sudden, and significant, rebound in economic activity, beyond that priced in, combined with increased money supply velocity would change the trend. The Fed may like the idea of letting inflation overheat, but even before the crisis the central bank failed to hit its inflation target of 2% for a sustained period.

While 0.5-0.6% seems to act as a floor for US 10-year treasuries, a sudden rise towards 1.5% or 2% appears unlikely. Achieving carry by considering investment grade bonds, selectively high yield bonds and potentially adding inflation-linked bonds, may be appropriate ways to navigate through the expected low-yield environment.

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