It’s an old maxim foreign exchange traders have learned down the years -- often to their cost -- and one that government bond traders may now have to get familiar with too: take on the central banks at your peril.
The heads of the US, euro zone and UK central banks are openly talking about potentially buying long-dated government and other bonds, an unconventional policy tool to pump cash into the system, fight recession and prevent deflation. Federal Reserve Chairman Ben Bernanke floated the idea on December 1 and his counterparts at the European Central Bank and Bank of England have since followed suit.
Central banks are contemplating this so-called “quantitative easing” after having already pursued an aggressive range of measures to mitigate the global credit crunch and economic fallout, including interest rate cuts and liquidity provisions. For government bond investors, this means thinking twice before cashing in on the recent rally. It also goes a long way to answering the question of where demand will come from next year to absorb the tsunami of issuance as governments fund their fiscal rescue packages.
“The risk of this happening should keep a constraint on the extent to which long end yields will rise in the coming months,” said Everett Brown, fixed income strategist at IDEAglobal. Because bond yields and prices move inversely, hefty central bank purchases of government debt would support prices and depress yields, thus keeping the benchmark cost of money, mortgages and other borrowing costs down. “It does risk inflation coming too high in the future but it’s more important to guard against the small risk of deflation in the present. It’s a risk worth taking,” Brown said.
PLAYING THE LONG GAME
Buying assets in the open market would be an option that would mirror the quantitative easing policies pursued by the Bank of Japan to combat deflation in the earlier 2000s. Then, the BOJ also targeted commercial banks’ current account balances at the central bank and employed ‘ZIRP’ -- a zero interest rate policy.
According to Barclays Capital, month-to-date total returns up to December 9 on US Treasury bonds of maturities of 20 years or more were 6.15%. That was 20 times the total month-to-date return on Treasury bonds of maturity between one and three years, and more than triple the return on any Treasury of up to 10 years. The month-to-date total return for Treasury bonds of 10-years’ maturity or longer was 4.37%.
To highlight just how much Bernanke’s comment gripped investors and fueled demand for US paper specifically, the month-to-date total returns on global government bonds of 10-year maturies or longer excluding the United States was just 1.99%, Barclays Capital data showed. Andre de Silva, deputy head of fixed income strategy at HSBC, cited similar figures that showed an index of 10-year or longer Treasury bonds was up 13.5% over the past month.
A large part of that, he said, was down to investors hoovering up government debt on the back of Bernanke. “It’s possible that central banks will buy (and) that makes you wary of positioning against that,” de Silva said. “This just shows they (Fed officials) are willing to do whatever is necessary: telling the market they’re prepared to take further measures, and this is one of them,” he added.
BALANCE SHEET BALLOON
The Fed has already expanded its balance sheet to an unprecedented degree, so nobody would really be surprised to see it go further and buy up large amounts of Treasuries, mortgage- or other asset-backed bonds. Yields on 30-year US and euro zone government bonds last week fell to historic lows near 3%, and UK yields a near-three year low of 3.70%. Comparable interest rate swap rates also fell steeply.
While these yields and rates have all recovered some ground this week, many analysts reckon the threat of central banks ready to put a floor under the market will be a dominant factor well into next year. Goldman Sachs says its models suggest “fair value” for US 10-year Treasury yields is around 3.30%. They were last trading at 2.70% on Wednesday.
“We expect them to trade expensive to the model (around 2.75%) as dysfunctional credit markets and rapidly falling inflation raise the possibility that the Fed may try to influence long-dated yields more directly,” the bank’s fixed income strategists wrote in a note this week.
In the few months the Fed’s balance sheet has ballooned almost threefold to $2.2 trillion, some 15% of gross domestic product, and is widely expected to cut interest rates in half next week to a mere 0.5%. Few would be surprised to see the Fed go all the way to ‘ZIRP’ early next year, something that more and more observers say the BoE, with rates currently at a half century low at 2%, could also do.
The inflation-conscious ECB may be less radical in easing monetary policy -- its benchmark rate is 2.5% -- and less inclined to pursue quantitative easing, analysts say. But after delivering its biggest ever rate cut of 75 basis points last week, Trichet said buying government or corporate debt is something the ECB is looking at “cautiously and attentively” and could be “possible”. (Reuters)