Opinion

Felix Salmon

The government-dominated bond market

By Felix Salmon
November 22, 2013

JP Morgan’s Nikolaos Panigirtzoglou put a fascinating report out last week, looking at supply and demand in the global bond market in 2014. And although I consider myself something of a bond nerd, I was genuinely astonished by some of the charts he put together, starting with this one:

demand2.png

This chart alone suffices to explain why the markets care so much about the taper: central-bank buying accounts for $1.6 trillion — more than half — of the total demand for bonds in 2013. Meanwhile, private banks are taking the opposite side of the trade: while they were huge buyers of bonds in 2007 and 2008, they’re net sellers in 2013 and 2014, more or less completely negating the buying pressure from pension funds, insurance companies, bond funds, and retail investors. In 2014, it seems, substantially all the net demand for bonds is going to come from the official sector. So it matters a great deal when that demand is diminished.

What’s more, central-bank buying, overwhelmingly from the Fed and the Bank of Japan, accounts for the lion’s share of official-sector buying: sovereign wealth funds and other foreign official institutions will buy just $364 billion of bonds this year, according to JP Morgan’s estimates, down from $678 billion last year. So the heavy lifting is still going to have to be conducted by QE operations, in the face of a taper which JP Morgan estimates at $500 billion over the course of the year. (The assumption is that it starts in January, and is completed by September.) Between the taper and other sources of diminished demand, total bond-buying firepower is likely to be $750 billion smaller in 2014 than it was in 2013. Bad news, for bonds, right?

Not so fast! It turns out that even as demand for bonds is shrinking, the supply of new bonds is shrinking just as fast:

Screen Shot 2013-11-22 at 4.45.23 PM.png

Again, this chart surprised me: I knew that government debt was a very important part of the total bond market, but I wouldn’t have guessed how important it was — or how fast it is shrinking.

Panigirtzoglou puts the two charts together, and you end up with this result:

In total we expect bond supply to decline by $600bn in 2014 to $1.8tr, more than offsetting the $500bn decline in bond demand due to Fed tapering. The balance between supply and demand, i.e. excess supply, looks set to widen from $140bn in 2013 to $280bn in 2014.

That number has pretty large error bars: you could pretty much cover the entire thing just by delaying the taper for three months. So let’s not worry too much about the difference between the two estimates, here. Instead, step back and look at the big picture, which is pretty simple: as a stylized fact, the bond market is dominated on both sides by the official sector. Private participants might sit in the middle as market-makers, or try to borrow money here or there, but overall what you’re looking at, when you look at the bond market, is government issuing debt and governments buying it.

The good news is that this large transfer of money from the official sector’s left hand to its right hand is slowing down, but that’s going to take a while. In any case, there doesn’t seem to be any conceivable way that the private sector could possibly be able to fund the still-substantial government deficits which have been bequeathed to us by the financial crisis. As a result, I suspect that QE is likely going to be around for a while, just as a matter of mathematical necessity. The world’s national deficits can’t get funded any other way.

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Now wait a minute here.

“we expect bond supply to decline by $600bn in 2014 to $1.8tr, more than offsetting the $500bn decline in bond demand due to Fed tapering. The balance between supply and demand, i.e. excess supply, looks set to widen from $140bn in 2013 to $280bn in 2014.”

If supply declines by $100bn more than demand, the balance (excess supply) should narrow by $100bn, not widen by $140bn.

??

Posted by ReutersRat | Report as abusive
 

“The world’s national deficits can’t get funded any other way.”

They could but only if interest rates rose to a level to balance the market. No more free money.

Posted by Knick | Report as abusive
 

Yeah, that’s a bit confusing. $500B of the decline in demand comes from the taper, but not all of it. There’s declines in demand elsewhere, too.

Posted by FelixSalmon | Report as abusive
 

Also:

Very odd use of “supply” and “demand.”

I think they mean here: “bonds issued” and “bonds purchased” (both: dollar value at sale?).

These must be equal, no, at least ex post?

Posted by ReutersRat | Report as abusive
 

In figure 3, domestically issued EM debts aren’t included. I wonder if the exclusion of those bonds – which are accounting for an ever greater share of EM sovereign debt (and even to some extent private debt)- can account for a large portion of the fall in bond supply. Clearly this is a question or scale. But I don’t really know just how large domestic EM bond markets are.

Posted by dbfried | Report as abusive
 

It’s clear that Treasury bonds will make a large move in the next few weeks– maybe as early as Friday 12/6 in response to the NFP report. Traders are leaning pretty short , and the move will probably be Up (lower rates), but you really don’t have to guess; due to relatively low option prices, you can buy both a put and a call to take advantage of the coming increase in volatility. Use options expiring in late January, and once the direction is clear, sell the losing side and let the winning side ride. Expect to double your money or more with this trade.
Conservative investors should look at closed end bond funds, which are selling at discounts that come around once every few years– esp in tax free bond funds and mortgage funds. Once tax loss selling runs its course in December, you will probably be looking at 5-7% gains by mid-February– a pretty good start to the year.
There is lots of emotion in the bond markets– strong opinions about rates– and this makes for lots of opportunity. What fun.

Posted by macrosophia | Report as abusive
 

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