Rates to rise in US as bond mar­ket rules the roost again


The sharp sell-off on Wall Street on Thurs­day night, which led that mar­ket into a tech­ni­cal cor­rec­tion and trig­gered swinge­ing losses around Asia on Fri­day, un­der­scores the role the bond mar­ket will play in de­ter­min­ing the fate of eq­ui­ties this year.

The S&P 500 closed down 3.8 per cent — its sec­ond-largest daily fall on record, by points — af­ter what has been de­scribed as “weak” de­mand in an auc­tion of 10-year Trea­sury notes saw yields rise (and, con­versely, bond prices fall) across all du­ra­tions.

The yield on 10-year Trea­suries spiked 72 ba­sis points to 2.83 per cent, only marginally lower than the 2.88 per cent yield on Mon­day amid the mael­strom that en­gulfed the share­mar­ket.

Af­ter nearly a decade where bond prices and yields were gen­er­ally of lit­tle rel­e­vance to eq­uity in­vestors be­cause cen­tral banks im­posed ul­tra-low ceil­ings on them, sup­press­ing volatil­ity across both mar­kets, bond mar­kets are slowly re­gain­ing their in­de­pen­dence.

Last Oc­to­ber the US Fed­eral Re­serve Board fi­nally be­gan the un­wind­ing of the legacy of its re­sponse to the fi­nan­cial cri­sis, the $US3.6 tril­lion ($4.63 tril­lion) pur­chases of US gov­ern­ment debt se­cu­ri­ties and mort­gage-backed se­cu­ri­ties via its three quan­ti­ta­tive eas­ing pro­grams.

In a very struc­tured pro­gram, broad­cast well ahead of its start­ing point, the Fed stopped rein­vest­ing some of the pro­ceeds it re­ceived from ma­tur­ing se­cu­ri­ties.

Ini­tially the amount it held on to was $US6 bil­lion a month of Trea­sury se­cu­ri­ties and $US4bn of mort­gage-backed se­cu­ri­ties and gov­ern­ment agency debt. Ev­ery three months, how­ever, those amounts es­ca­late by $US6bn for Trea­suries and $US4bn for the other se­cu­ri­ties un­til the Fed is re­tain­ing $US30bn a month from ma­tur­ing Trea­suries and $US20bn a month from ma­tur­ing mort­gaged-backed and agency debt.

That means that the Fed will not rein­vest about $US230bn of the $US425bn of the Trea­suries it holds that will ma­ture over the course of this year. The flip side of that, of course, is that pri­vate buy­ers will have to be found to re­place the Fed as a source of de­mand for US gov­ern­ment debt.

The steadily di­min­ish­ing role of the Fed as the big­gest source of de­mand for Trea­suries — and the re­duced im­pact of its pur­chases on the US yield curve — will with­draw liq­uid­ity from the US bond mar­ket and al­most cer­tainly flow through to the rates re­quired to at­tract de­mand for new is­sues.

With the av­er­age ma­tu­rity of the Fed’s hold­ings about six years, the US Trea­sury has had to change its fi­nanc­ing strat­egy to re­duce the amount of new longert­erm debt it is­sues to avoid a se­vere steep­en­ing of the yield curve.

With the Fed both rais­ing rates — five 25 ba­sis point in­creases so far in this cy­cle and three more flagged for this year — and grad­u­ally scal­ing down its pres­ence within the mar­ket, how­ever, it is al­most in­evitable that rates will rise and that the yield curve will steepen as the term premium, long sup­pressed by the Fed’s as­set-pur­chas­ing pro­grams, re-emerges. (That premium should re­flect the risks, in­clud­ing in­fla­tion, of hold­ing longer-dated se­cu­ri­ties rel­a­tive to the overnight cash rate).

The US Trea­sury is sched­uled to tap the debt mar­kets for a net $US955bn this year, an ap­par­ently huge in­crease on the $US520bn it raised in 2017 but one which is im­pacted by the Fed’s fall­ing rein­vest­ment. The Fed has pur­chased its se­cu­ri­ties sep­a­rately to the auc­tions con­ducted by Trea­sury, so the size of the auc­tions has had to be in­creased to re­flect its re­duced de­mand.

Nev­er­the­less, it is a very size­able fi­nanc­ing task at a mo­ment when it’s not just the Fed mov­ing to nor­malise mone­tary pol­icy. The Euro­pean Cen­tral Bank, hav­ing al­ready heav­ily scaled back the size of its as­set-pur­chas­ing pro­gram, is widely ex­pected to halt it by the end of the year.

The ma­jor cen­tral banks, hav­ing spent the past nine years hos­ing fi­nan­cial mar­kets with near cost­less liq­uid­ity, are slowly clos­ing the spig­ots.

In the US, with solid eco­nomic growth and un­em­ploy­ment at lev­els re­flect­ing an econ­omy near­ing its ca­pac­ity, Don­ald Trump’s tax cuts for com­pa­nies and higher net worth house­holds are go­ing to add some­thing to the growth rate and the prospect of in­creased in­fla­tion.

US rates are a long way from their “nor­mal” lev­els. Be­fore the cri­sis started to emerge, in mid-2007, for in­stance, yields on the 10-year bond rate were above 5 per cent as, in­deed, was the fed­eral funds rate.

What­ever nor­mal might look like over the next few years, US and eu­ro­zone rates are likely to be ma­te­ri­ally higher — in the ab­sence of a re­ces­sion or fresh cri­sis — by the time the Fed has fin­ished its pro­gram of nor­mal­is­ing US mone­tary pol­icy than they are to­day.

That wouldn’t nec­es­sar­ily be bad for stocks — it would be a sign of grow­ing economies — but it would see bor­row­ing costs for com­pa­nies and gov­ern­ments rise. To the ex­tent that eq­uity val­ues have been in­flated by the ab­sence of in­vest­ment al­ter­na­tives, a rise in bond yields might also see the cen­tral bank-in­flated el­e­ment of the val­u­a­tions evap­o­rate.

The cen­tral point to take from this week’s skit­tish­ness in the US and other eq­uity mar­kets, how­ever, is that it dawned on mar­ket par­tic­i­pants that, af­ter nearly a decade where cen­tral banks pur­sued strate­gies de­signed to en­cour­age risk-tak­ing and sought to spark some in­fla­tion, the Fed, at least, is now be­gin­ning to fo­cus on more tra­di­tional pri­or­i­ties.

That has some po­ten­tially very un­set­tling im­pli­ca­tions for mar­kets that, for near a decade, have had cen­tral bank safety nets be­neath them and have be­come very com­fort­able in that knowl­edge.

Mon­day’s mar­ket im­plo­sion and the im­me­di­ate re­sponse overnight to the lack­lus­tre de­mand in an auc­tion of Trea­suries were tastes of what might hap­pen if the nor­mal­i­sa­tion of mone­tary poli­cies and yield curves — the safety nets — hap­pens faster than the mar­kets have an­tic­i­pated.

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