By Jamie McGeever
LONDON, Sept 27 (Reuters) - As central banks prepare to unwind their crisis-fighting stimulus measures, bond yields should rise as these buyers of last — indeed, first — resort step back from the market.
At least that’s the theory. But with the private sector ready to muscle its way back in after a decade of being crowded out, it may not work out that way.
Since G4 central banks unleashed a tsunami of quantitative easing after the 2007-09 crisis, their collective footprint in the bond market has grown substantially. The private sector’s collective footprint has shrunk.
The Federal Reserve, European Central Bank, Bank of England and Bank of Japan combined balance sheet stands at around $14 trillion, of which just under $10 trillion is conventional government bonds.
Before the crisis they held barely more than $1 trillion of bonds between them, and that was just the Fed and BOJ. If — and it’s a big if — there is to be a return to pre-crisis conditions, that’s a lot of bonds for the private sector to absorb.
“The evidence suggests the market can accommodate the unwinding of QE relatively well, partly because there’s an expectation that some of the balance sheet tightening will substitute for aggressive rate hikes,” said Brad Setser, senior fellow at the Council on Foreign Relations in Washington, D.C. and a former economist at the U.S. Treasury.
Deutsche Bank’s chief international economist and former IMF economist Torsten Slok shows that U.S. investors sold out of European bonds en masse when the ECB stepped into the market.
Forced out of sovereign debt and into riskier assets such as corporate and high yield bonds, private sector investors are now underweight government bonds relative to where they would have been absent QE, he reckons.
So although QE has pushed yields to the lowest in history - below zero in Japan and across Europe - the private sector is ready and waiting in the wings. The only question is at what price.
Pension and insurance funds need to match their assets with liabilities. They have a longer-term, more conservative investment outlook so government bonds - traditionally among the safest and most liquid of assets - fit that criteria and their bid for bonds is relatively price insensitive.
The private sector - pension and insurance funds, domestic and overseas banks, households and other financial institutions - has seen its share of the G4 sovereign debt market fall, but it varies from region to region.
In the United States, the Fed has long held a chunky share of Treasury debt on its balance sheet. Indeed, its share of the bond market is lower today than it was pre-crisis, despite QE, because the ballooning fiscal deficit has fueled even greater issuance.
So the private sector hasn’t been crowded out of the U.S. Treasury market much at all.
The Fed is also further ahead than its peers in unwinding QE. It has held its balance sheet steady for three years, and next month will begin shrinking it by gradually reducing the amount it reinvests and allowing bonds to mature.
When the Fed’s balance sheet stopped expanding in late 2014, the 10-year Treasury yield was around 2.40 percent. When the Fed first raised rates in December the following year it was around 2.20 percent. Three rate hikes later and with a taper path clearly outlined, the yield today is 2.25 percent. So, clearly, no bond market collapse.
It’s a different picture in Europe. The ECB holds 2 trillion euros of government bonds, or nearly a quarter of outstanding euro zone debt. In 2007, it held less than 300 billion euros, or 5 percent of the total.
Before the crisis, the Bank of England’s UK government bond holdings were even smaller, virtually zero, while domestic and overseas private investors held over 90 percent. The only official sector holders were foreign central banks.
Now, the BoE holds around 25 percent of all gilts. Once overseas central banks’ foreign exchange reserves are taken into account, only around 70 percent of the UK government bond market is in private sector hands.
Reporting by Jamie McGeever Editing by Jeremy Gaunt