2016-10-19 FIL Mind the safety gap

PERSPECTIVE October 2016

This is for investment professionals only and should not be relied upon by private investors

Mind the (safety) gap

Government bonds have long been deemed safe assets, almost

guaranteeing investors the risk-free rate of return. But what happens when

you cannot get your hands on such safe assets? That could soon be a

reality for central banks, as supply and demand appear increasingly

mismatched.

The Bank of Japan’s recent policy adjustment may indicate that policy

makers are factoring this into plans. With USD 10.2 trillion in bonds yielding

a negative return or owned by central banks, the downward pressure on

yields could become less pronounced. Beyond technical arguments, the

structural conditions for a ‘lower for longer’ outlook remain in place.

Long government bond trade becoming crowded

Investors in ‘safe assets’1 are finding it increasingly hard to invest in positive

yielding securities as the proportion of positive yielding assets compared to the

entire asset class shrinks.

Globally, safe assets amount to USD 27.3 trillion (chart 1), a number that has

been growing steadily as governments have stepped up their issuance to finance

widening fiscal deficits. If we subtract all bonds already owned by central banks

or with a negative yield, this leaves a pool of around USD 17.1 trillion (or 63% of

the asset class) in available, positive-yielding safe assets. At the same time, the

demand for safe assets has risen due to regulatory constraints on banks and

insurers as well as general risk aversion in the face of negative real yields.

As a result of the sizeable quantitative easing (QE) programmes implemented by

global central banks, the pool of available of safe assets is shrinking rapidly.

AT A GLANCE

Central bank policy has led to

a significant supply/demand

mismatch in sovereign bonds

Resulting scarcity issues may

well be behind the BoJ’s

recent policy shift

Other central banks are also

likely to adjust policy, easing

downward pressure on yields

However, longer-term

structural factors will continue

to weigh on yields

Dierk Brandenburg

Senior Sovereign Analyst [email protected]

Andrea Iannelli

Investment Director [email protected]

Adnan Siddique, CFA

Investment Writer [email protected]

Aimee Stewart

Data Visualisation Editor [email protected]

Chart 1: Negative yielding & central bank owned government bonds nearly 40% of market

Chart 2: Central banks’ large appetite for ‘safe’ debt Tips for using this placeholder

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2013 2014 2015 2016 2021% of US GDP % of JPY GDP % of Euro GDP

Fed Mkt Share BoJ Mkt Share ECB Mkt Share

2021 Forecast

Govt bond holdings as share

of total market and GDP

Source: BAML Fixed Income Indices, Haver, Fidelity calculations, Sept 2016 Note: 2021 estimate based on extrapolating 2016 monthly buy rate as percentage of expected government bonds outstanding based on IMF budget forecast

Source: FRED, ECB, BoJ, Sifma, OECD, IMF, Fidelity calculations, Sept 2016

PERSPECTIVE | Mind the (safety) gap 2

With the European Central Bank (ECB) and Bank of Japan (BoJ) already owning

15% and 38% of their respective government bond markets (chart 2), investors

have begun to wonder whether there are enough safe assets in circulation to

satisfy both central banks and investors.

Monetary policy actually may not be too far from its limits and bond scarcity is an

issue that central banks will soon need to address.

Rise of scarcity in some of the most liquid markets

Developed market sovereign bonds are among the most liquid assets in the

market, partly because of the huge volumes in circulation and partly because of

government issuers’ high likelihood to make good on the debt. By venturing into

the market with QE, central banks have severely disrupted the balance between

demand and supply. As a result, yields are now below the levels seen during the

Great Depression of the 1930s and both world wars (chart 3) and 37% of

developed market government bonds pay a negative yield.

Chart 3: Sovereign bond yields lower than ever Tips for using this placeholder


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Yield (%)

Germany

UK

USJapan

Source: Bloomberg, Datastream, GFD, NBER, Minack Advisors, July 2016

Analysts and the press have long been warning that this disequilibrium could be

spilling over into outright scarcity, and their concerns intensified over the summer.

Some of these concerns are now being echoed by central bankers.

The BoJ’s change of tack on 21 September could be the first solid indication of

this scarcity impacting policy and the markets.

The BoJ’s announcement to shift its focus to targeting a zero-percent 10-year

yield has been interpreted by some as an admission that QE is no longer

implementable in its current form. Although BoJ Governor Haruhiko Kuroda

claimed that there will be no significant change in the level of bond purchases,2

the BoJ move at least suggests that QE is approaching its limit of effectiveness.

The ECB is not yet facing quite such a dearth of suitable bonds to buy, but there

are growing signs of scarcity. The ECB’s bond holdings as a proportion of the

market are smaller than the BoJ’s and even the Fed’s, but its share is rising fast

(chart 2).


Additionally, it has a self-imposed restriction of owning no more than 33% of any

country’s outstanding debt and no more than 25% of outstanding CAC (collective-

action clause3) debt. Yet the ECB owns 21% of all outstanding German bunds

(chart 4) and could find it has broadly reached the country limit within 15 months

(chart 5), assuming purchases continue through March 2017 at the target pace.

This is further complicated by another rule; the ECB cannot purchase bonds

yielding below the ECB’s deposit rate – that excludes 43% of German bonds, one

of the largest and most liquid sovereign bond classes.4 At its September press

conference, the Bank did not specifically mention investigating bond scarcity, to

the chagrin of some commentators, but it did say it had “tasked the relevant

committees to evaluate the options to ensure a smooth implementation of our

purchase programme”.

The final restriction is the ECB’s capital key. This prescribes the proportion of

bonds to buy from each issuer based on the size of the country’s population and

economy. For Germany, the capital key indicates 25% of all bond purchases

should be from this country. Given that 43% of German bonds trade below the

deposit rate, it’s becoming increasingly difficult for the ECB to fulfil the capital

key.

Chart 4: Will there be enough bonds for the ECB to buy?

Chart 5: Gone in 15 months?

Note: Includes cumulative Public Sector Purchase Programme debt securities plus Securities Markets Programme holdings, as a proportion of outstanding central government debt per country at Sept 2016. Only countries with debt exceeding EUR 70 billion included.

Source: ECB, Fidelity calculations, Sept 2016

Note: This is a stacked chart so each country’s time remaining is read independently e.g If ECB bought EUR 80bn/month in French debt, it would reach France’s country limit in 4 months.

Source: ECB, Fidelity calculations, Sept 2016

The ECB’s QE mandate expires at the end of March 2017, but may be extended,

with President Mario Draghi saying “the monthly asset purchases of EUR 80

billion are intended to run until the end of March 2017, or beyond, if necessary”.5

Prolonging QE would widen the gap between supply and demand in the market.

Scarcity could be further compounded by regulatory and liability-matching

requirements affecting demand for sovereign bonds by money market funds and

insurers. Investors’ risk-aversion in the current climate doesn’t benefit the

equation either, helping to turn risk-free assets into return-free assets.

If there is an impending scarcity crunch, how could policy makers respond?

Months remaining

until 33% issuer

purchase limit

reached by ECB

(at target rate of

purchase)


Policy-makers fight back

Japanese and European central bankers have a number of options in light of a

lack of purchasable bonds for QE. One is to cut back on QE. This has the

potential of a repeat of the 2013 taper tantrum when yields soared on signs that

the Fed was to curtail QE. Given the level of bond duration (the price sensitivity to

changes in yield), tapering could play havoc with bond prices (chart 6).

In January 1991, a 10% fall in the price of the BAML Sovereign Bond Index led to

a yield rise of 210bps (basis points). In the 2013 tantrum, a yield rise of 150bps

led to a 10% price fall. The non-linear relationship between yields, where a

change in yield at a lower absolute level leads to a disproportionately larger bond

price swing compared to higher yield levels, means that today a yield increase of

only 120bps is associated with a 10% price drop. In short, bond prices are now

nearly twice as sensitive to yield moves as they were 25 years ago.

Chart 6: Rising yield-to-maturity raises price volatility Tips for using this placeholder


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1991 1996 2001 2006 2011 2016

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Yield to Maturity (LHS) Modified Duration (RHS)

Source: BAML Fixed Income Indices, Fidelity calculations, Aug 2016

However, there is a major difference between the 2013 event and a potential

tapering scenario now. The 2013 episode involved the Fed tapering in response

to a recovering economy, or at least falling unemployment. Tapering in Japan

and Europe today would hinge on a lack of purchasable bonds. A shortage of

bonds doesn’t necessarily change the underlying economic fundamentals and

could mean that central banks employ other stimulatory measures, which would

weaken the impact of the tapering signal to the market. Additionally, a lack of

available bonds to short in itself could curb selling pressure and help avoid the

yield spikes of 2013.

The BoJ’s move to targeting yield levels could be an alternate option for central

banks if they struggle to find bonds to buy. A credible central bank committed to a

target yield could send a strong message to the market, avoiding a situation

where traders concertedly test policy-maker resolve. This could end up

containing yields with less overall central bank intervention. Again, a lack of

available bonds in the market would be to the advantage of central banks by

undermining any investor attempts to bet against the policy-makers because of

the difficulty in sourcing assets to buy or take short positions in. Central banks

also have the option to sell bonds if yields drop below the target rate.


Governments could also resort to fiscal measures to promote economic growth. If

governments issued debt to finance fiscal stimulus it would boost the supply of

bonds and could allow central banks to maintain QE. Such measures may help

encourage growth and inflation, making central bankers’ jobs easier and even

alleviate the scale of QE required.

Fiscal policy is not without its drawbacks, however, and Japan’s fiscal stimulus of

the last 20 years has provided only short bursts of inflation before deflation

reappeared.

Chart 7 tracks Japan’s inflation and fiscal stimulus as proxied by the country’s

primary balance (government net spending, stripping out interest costs of

previous debt), as a percentage of GDP.6 A negative primary balance/GDP

indicates the government is spending more than it generates from revenues and

is fiscally expanding. The chart shows Japan has consistently had weak or

negative inflation in the past 20 years despite sustained fiscal stimulus.

Chart 7: Japan’s fiscal stimulus packages did not lead to lasting inflation Tips for using this placeholder


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-6.0%

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1996 1998 2000 2002 2004 2006 2008 2010 2012 2014

Primary Balance/GDP (RHS) CPI Annual (LHS)

Note: A negative primary balance/GDP indicates fiscal stimulus

Source: Thomson Reuters Eikon, IMF, Japan Ministry of Finance, Dec 2015

The fiscal measures of the late 1930’s following the Great Depression and

military spending in the early 1940s took years to take hold; only leading to

growth in the late 1940s.7

Given structural trends limiting growth, yields will trend low in the long term even

with an expansionary fiscal policy agenda - notwithstanding cyclical patterns and

occasional spikes - QE tapering being one possible hiccup.

Conclusion

The BoJ’s recent policy actions imply that bond scarcity could be a reality and

that central banks are factoring it in to decision-making. The ECB doesn’t have

the same level of bond scarcity tension as the BoJ, but there are signs that such

pressures are building. Any decision by the ECB to extend QE beyond March

2017 makes scarcity more likely to be an issue in the European bond market.

Given these concerns, central bankers may consider alternative stimulative

policies.

If the scarcity argument does impact policy, it could potentially ease downward

pressure on yields in the short term and medium term. In the longer term

however, the drag from structural forces will keep a lid on upward yield potential.


REFERENCES 1

Defined as key sovereign bonds with maturities from 0 to 30 years.

2 Reuters – “BOJ’s Kuroda see no big rise or fall in bond buying for now” – 26 September 2016.

http://www.reuters.com/article/us-japan-economy-boj-idUSKCN11W0E7

3 A CAC (collective-action clause) allows a supermajority of bondholders to agree on a restructuring in

the event of issuer stress rather than requiring all bondholders to agree.

4 43% German bonds trading below deposit rate as of morning of 19 October.

5 ECB Introductory statement to the press conference (with Q&A) – 8 September 2016.

https://www.ecb.europa.eu/press/pressconf/2016/html/is160908.en.html

6 Instituto de Estudios Fiscales – “How to measure a fiscal stimulus” – Francisco de Castro (Banco de

Espana), Jana Kremer (Bundesbank) and Thomas Warmedinger (ECB) - May 2010.

http://www.ief.es/documentos/recursos/publicaciones/revistas/presu_gasto_publico/59-06.pdf

7 The top 12 western European countries averaged GDP growth negative 1.1% from 1937-1946 and

6.0% from 1947-1956 according to University of Groningen Growth & Development Centre.

www.ggdc.net/maddison/Historical_Statistics/horizontal-file_02-2010.xls

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http://www.reuters.com/article/us-japan-economy-boj-idUSKCN11W0E7

https://www.ecb.europa.eu/press/pressconf/2016/html/is160908.en.html

http://www.ief.es/documentos/recursos/publicaciones/revistas/presu_gasto_publico/59-06.pdf

http://www.ggdc.net/maddison/Historical_Statistics/horizontal-file_02-2010.xls

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2016-10-19 FIL Mind the safety gap