Domestic Bonds

Analysis: Shaken but not shaken: Bond markets could face hawkish Fed for now


By Dhara Ranasinghe

LONDON (Reuters) – A hawkish turn within the U.S. Federal Reserve has ended a multi-week rally in bond markets, but don’t bet on a repeat of the steep decline seen earlier this year.

US 10-year bond yields returned above 1.5%, near two-week highs, while the German Bund yield hit a three-week high of around -0.15% on Thursday.

Investors marked by a massive bond selloff in February, which also hit stocks, have reason to be concerned.

Still, unusual short-term supply and demand dynamics and strong global demand for safe-haven bonds, squeezed by an acceleration in money printing over the past year, could limit a sell-off.

Such forces may also help explain why bond markets have been shown to be resilient as inflation, the enemy of fixed income, rises. US inflation hit 5% in May, its highest level since 2008, while in Britain and the eurozone inflation has exceeded targets by around 2% as economies emerge from lockdowns .

And even with tapering, the strong presence of central banks will remain significant.

“The surge in yields is not magnified this time around as the positioning is clearer and the fundamentals have not changed – the Fed will be buying bonds for a long time,” said Frederik Ducrozet, strategist at Pictet Wealth Management.

The pool of top-rated debt available to buy in global reserve currencies has certainly shrunk, presenting a powerful downward force on yields in Europe and the United States.

In the eurozone, the European Central Bank sucked up bonds as part of its € 1.85 trillion ($ 2.21 trillion) pandemic program – it now holds nearly a third of German, Dutch and Finnish bond markets.

Analysts believe this has helped push the float in benchmark issuer Germany’s bonds to less than 20% from all-time lows.

(Charts: German bond float drops –

The ECB buys around € 80 billion of bonds per month for emergency stimulus alone, and the supply of new debt is slowing; ING estimates the gross supply of euro area government bonds at around € 293 billion in the third quarter compared to € 364 billion in the second.

Bond purchases by central banks in the euro area, Japan and the UK against underlying budget deficits are 161%, 110% and 129%, respectively, according to Eurizon SLJ Capital estimates. They effectively withdraw more bonds than governments sell.

In contrast, the Fed’s equivalent purchase ratio is 37% of US deficits – the impact has been to almost double the share of Treasuries over the past decade in the four ‘floating’ global bond indices. main reserve currencies at 60%.

“The continued reduction in free float has a significant impact on the level of returns,” said Patrick Krizan, economist at Allianz Research.

Chart: US Treasury issuance vs. Fed QE


This comes at a time when unusual – albeit temporary – factors in the United States are keeping government bond yields lower than they would otherwise be, experts say.

The U.S. debt ceiling, a ceiling imposed by Congress on how much the government can borrow, will be re-imposed on July 31 after being suspended during the pandemic.

To avoid crossing the ceiling, the US Treasury has exhausted its cash. As of June 9, its cash balance was around $ 670 billion, up from $ 1.8 trillion last October. It is targeting $ 450 billion on July 31.

As cash is drawn from the general treasury account, bond issues were lower than expected.

Robin Brooks, chief economist at the Institute of International Finance, estimates that issuance for the three months through June will reach $ 70 billion, well below forecast of $ 463 billion and less than the $ 240 billion that the Fed buys quarterly.

Much of the money spent by the treasury ends up in bank balance sheets, often in money market funds.

The extent of money market liquidity was evident on Monday when the Fed accepted a record $ 583.89 billion in offers for its overnight repo facility, up from $ 450 billion three years ago. weeks and almost nothing in March.

This excess liquidity squeezes the yields of short-term money market instruments, weighing down on government bond yields.

Structural demand by US pension funds for Treasuries and bond inflows from domestic investors are also depressing yields.

David Kelly, strategist at JPMorgan Funds, notes that data from the Investment Company Institute shows more than $ 350 billion was invested in long-term bond funds and exchange trading funds this year, up from $ 152 billion. dollars in shares.

“There is a significant structural demand,” said Josh Lohmeier, head of investment grade credit at Aviva North America.

Chart: Free float share of US Treasuries

(Reporting by Dhara Ranasinghe in London; additional reporting by Karen Pierog in Chicago; Editing by Tommy Wilkes and Pravin Char)