Central Banks vs Bond Markets
Bond yields are rising swiftly after hitting rock bottom about 6 months ago. Although yields are still now very low compared to the past 10 years, the rapid change in yields is disruptive to all markets and could disrupt housing as well. All this is causing a growing headache for central banks, with 3 combined issues: expectations, credibility, risk.
When federal bond yields rise, all asset markets are impacted. Since bond yields influence all other asset returns, this in turn adds upward pressure to corporate bond yields, thus making debt servicing harder. It adds downward pressure on stock prices (yields and asset prices go in opposite direction), and can also act as a drag on real estate.
Bonds are debt securities sold (initially) by those who borrow: I sell you a 100 000$ bond for less than 100 000$ now and you get 100 000$ later (plus regular payments in some cases). The benchmark for all “interest rates” in the economy is the 10 year federal bond yield. It serves as a barometer for all other yields and interest rates, hence also for asset prices. We will thus use “yields” and “interest rates” interchangeably in this text.
5 fundamental things influence bond yields:
- Supply and demand now.
- Expected future demand and supply.
- Expected inflation (more inflation = rising interest rates).
- Central bank policy.
- Expected central bank policy.
I will not explain one by one all of these, as it would be too long. Suffice to remind ourselves that 1) interest rates and asset prices go in opposite direction and 2) you don’t want to hold assets whose prices are at risk of falling.
So. With these 5 above forces in mind and the 2 reminders, lets talk about the emerging war between central banks and the bond market…
There has been a HUGE rise in the supply of bonds, because governments have increased debts quite a lot in the past 10 years and with steroids in the past year. Increase in supply = falling prices = rising yields. But demand was there to meet supply, so the rise was moderate, as increasing demand met increasing supply.
Central banks have also played a huge role as well, by creating money and buying bonds, effectively reducing market supply:
Now this reduction in the supply of bonds in the open market causes one thing to happen: inflation. Indeed, prices and money stock are correlated in the long run. It is a long story, but the short story is that when M2 money stock rises significantly, prices rise… rising prices = inflation = increasing interest rates = falling asset prices.
The money-prices story is not that simple, because there is also the issue of the “velocity of money” and the quantity of goods and services produced. Again a long story, but in a nutshell, velocity influences inflation and GDP influences inflation as well: if more goods are produced, then a rising money supply is “chasing” a rising quantity of goods and services, so this is NOT inflationnary. Inflation rises when you have the money stock increasing faster than GDP: more dollars are chasing goods and services, and prices start to rise faster, with a roughly 1-year “lag”, meaning that when the money stock rises, prices react a bit later.
Now to complicate things further, there is a difference between the monetary base and the effective money supply, but to keep things short, I’ll just say that what really matters is the effective money supply, which is well captured with the “M2” money aggregate:
The “jump” of M2 that you see in 2020 is partially what is causing inflation expectations to rise for 2021–2022… but what is adding to the mix is that velocity may NOT fall going forward, as velocity is “procyclical” and we are in an upward economic cycle, so at best velocity will probably remain constant.
I did a back-of-the-envelope calculation with the “exchange equation” MV = PY, hence P = MV/Y. Keeping V constant (an optimistic hypothesis) and taking into account that the approximately -500 billion USD negative output gap will “absorb” the money supply without inflation, I calculated that if M2 rises by 2 trillion withing the next year and that 500 billion will be non-inflationnary due to the output gap, the “inflationnary M2” will be about 1.5T (1500 billion), or 8% growth. Supposing GDP growth of 5% for 2021–2022, we get about 3% inflation for 2021–2022: 8%-5% = 3%.
The blue line is my “estimation” and the red line is actual inflation. This estimation of 3% inflation for 2021–2022 is conservative, as it removes 500 billion from the picture and it supposes GDP 5% growth and it supposes zero change in velocity. 3% inflation is no problem.
IF we fully integrate M2 growth 2021–2022 (without removing the 500 billion negative output gap) AND GDP growth is 4% instead of 5% AND velocity increases by 1%, then you get 8% inflation…
8% inflation is a whole other ball game, and all this is totally possible. 8% inflation would be a problem. A big one. A BIG BIG ONE. What happens when governments and firms are racked up in debt and interest rates rise? Pressure. What happens to stock indices when interest rates rise sharply? Pressure. What happens to real estate when interest rates rise sharply? Pressure. Such inflation would be problematic, to say the least. In fact, it would be quite catastrophic, to be honest.
This uncertainty about the inflation outlook is what is roiling markets worldwide.
What is expected for 2021–2022? A growing economy, hence at best a constant money velocity. A huge Biden stimulus package and government debt, hence MORE bond supply coming down the pipe, hence downward pressure on bond prices down the road, hence falling demand now (who wants to hold something that will have falling prices?). The fall in demand now adds downward pressure to bond prices, hence upward pressure to bond yields and interest rates:
So markets expect rising bond supply AND rising inflation, hence falling bond prices and rising interest rates (hence falling bond prices), which feeds falling bond demand now, which feeds rising bond yields and interest rates now.
Enter Central Banks!
If rising interests rates pose a threat to macro-financial stability, the typical move by central banks is obvious: BUY BONDS with money creation. Indeed, the Fed can just type in “+1 trillion dollars” for free and use it to buy bonds. This removes bonds from circulation, hence reducing supply, which increases bond prices and decreases bond yields and interest rates. Don’t fight the Fed. Right?
Without inflation, central banks can create all the money they want and thus indeed keep interest rates from rising and disrupting markets and the economy. As I said before many times, no inflation, no problem.
BUT what happens if inflation starts flirting with 4% or 5%… or 7%-8%? THEN the implicit promise to eternally intervene with bond-buying-with-money-creation has falling credibility.
Central bank officials then start to “talk down the market” by saying that they will tolerate inflation for some time, blablabla. They hope the market will believe them, and it works most of the time… but sometimes, when the planets are aligning, bond traders may think the pressure is about to become too big and shorting bonds is a risky but potentially VERY LUCRATIVE BET.
You thus get a gradual fall in bond demand with rising bond supply and a falling credibility of central banks to eternally buy bonds to keep bond prices high and interest rates low. Large speculators start shorting bonds, which adds to the downward pressure on bond prices, hence upward pressure on interest rates and downward pressure on stocks and real estate. With stocks and real estate at high valuations, this can become a tense situation if inflation starts rising above 5%.
It is in such a context that emerges a war between central banks and bond markets, or rather a poker game, each side wondering if the other side is bluffing or not, and how much courage and “ammo” they have to stay the course.
The central bank can “destroy the shorts” by waiting a bit for speculators to add short positions, then buying bonds, which increases prices and wipes out short positions. The “hurt” inflicted on short speculators is hoped to act as a lesson to never mess with the central bank, and if it works, bond prices stop falling and expectations of future falling bond prices ease, and this keeps interest rates from rising too much.
But how much of this can the central bank do? The answer entirely depends on inflation. No threat of inflation means high credibility of the central bank to buy bonds, hence to keep interest rates low. BUT if inflation becomes threatening, then markets start calling the central bank bluff… and then the central bank gets stuck with a credibility problem: do you keep your credibility about bond buying and keeping interest rates low OR do you keep your credibility about keeping inflation in check by not printing money?
The Fed currently is essentially saying this:
“We will buy bonds whenever we want if we estimate that rising yields pose a systemic risk to markets and the economy, and any rising inflation will be temporary and not permanent, hence not a real problem.”
It is a lot about communications strategy, and it is quite the delicate dance.
What the Fed hopes is that bond markets wont go nuclear in their challenge to this Fed conundrum / bluff, because if bond markets go nuclear, even the Fed could have trouble, and that would mean a significant interest rate shock for 2022–2023, with a nasty knock-on effect on markets and the real economy. I am not saying it will happen, but the risk is real and the potential result is quite the nightmare, with elections in 2024 to top it all off.
FOR NOW, my guess is that inflation will remain in check and so things will be all good… but it very much depends on inflation going forward.
What about inflation?
Inflation for now is low, but food inflation is rising in the USA and many large emerging countries, the price of oil is rising quickly, and commodities inflation is quite high as well, with no sign of abating.
Same story for oil: low level, but lots of upward momentum, entering a context of a growing economy with disrupted supply chains due to covid lockdowns and the known-on effects of the last year supply disruptions…
The poker game between central banks and bond markets is just beginning and will intensify in 2021–2022. For now, central banks have an ace up their sleeve: low inflation. But this could change in 2022–2023, as output gaps go to zero and huge jumps in money supplies meet stable or rising velocity as well as lots of bond supply worldwide. With huge debt loads, high asset and real estate prices, rising geopolitical tensions and domestic political divisions, an interest rate shock could be catastrophic. Keep an eye on inflation and on 10-year bond yields. Clap and share. Regards.