What a buyers strike in long bonds means for the global economy
Last Friday we saw Moodys downgrade US debt from Aaa to Aa1, and yesterday a weak auction in 20 year Japanese government bonds sent their yields spiking by 15 bp to the highest level since 2000. Global bonds simply cannot catch a break, and there is a buyers strike in the long end of many developed market bond markets.
Let’s take a step back and look at the benefits of countries issuing bonds with maturities of 30 years and longer. For one thing, the government doesn’t need to give that money back for an entire generation, and therefore can avoid having to roll it over for a long time. Another benefit is that it creates a “risk-free” yield that other long maturity debt can be priced from - think mortgages, corporate debt, and state and municipal bonds.
A buyer of 30 year government debt would need to have confidence that throughout the life of the bond, the government will not sanction the bond holder, impair or restructure the debt, deliberately weaken their currency, or allow inflation to persist at a rate above the yield at which the debt was sold. At the very least, there should be a a willing buyer who can take the debt off the holder’s hands at a profit. From the inflationary 1980’s to the culmination of global QE in 2021, that was a winning bet for government bond holders. However, the events over the past several years have proven to Treasury holders that none of the above is assured any more. If 2-3 years is all it takes for confidence in government debt to be shaken, then imagine what can happen in 30 years?
After the Bank of Japan announced it would gradually scale back its bond purchases last year, the JGB market started the process of repricing yields to a level where institutional buyers get compensated for holding bonds after inflation and FX volatility are factored in. Japan plans to hold an auction of 40 year JGBs on May 28, which suggests the process of repricing will continue for a bit longer. With Japan CPI at 3.6%, the 30 year JGB’s yield of 3.1% is probably not high enough.
The buyers strike in JGBs will have a ripple effect in both the Japanese economy and the rest of the world. Starting with Japan - as local JGB yields become more attractive for banks and pension funds relative to international bonds, these institutions might choose to repatriate their foreign holdings back to Japan, causing the yen to strengthen against the dollar.
If the cost of borrowing at the 20 year maturity and longer becomes too punitive for the government, they would have no choice but to issue less on the long end and more at 10 years or shorter. As the supply of debt moves up the curve from the long end to the middle and short end, borrowing costs will escalate across the entire curve and tighten financial conditions. At some point the Bank of Japan may capitulate and decide that their tapering of JGB purchases is counterproductive, and return to QE. This would cause the yen weakening trend to resume and also increase the supply of global monetary liquidity.
The consequence of repatriation flows away from Treasuries back into JGBs is enormous. Japan is the largest holder of US debt, with $1.13T of holdings. The rise in US Treasury yields has been a result of selling by private institutions and China’s foreign reserve manager, but Japan’s holdings have remained constant, according to Treasury data. If they were to start adding to this wave of selling pressure, the bond market would not be able to absorb the supply without a material repricing higher in yields.
The corner of the global economy that depends most on long end yields would be the US housing market, which relies on 30 year mortgage financing for the vast majority of loans. If 30 year yields were to rise uncontrollably to 6 or 7%, that would equate to mortgage rates in the vicinity of 8-10%. Rates at this level would make the American dream of home ownership even more unattainable as it already is. It’s unlikely policymakers would stand by and let this happen without some kind of intervention, either fiscal or monetary.
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