Blain’s Morning Porridge May 29^th 2024: In Bonds There is Truth – Central Banks’ Truth

“Bring me the finest wines in the world, and bring me them now…”

It was once holy scripture that government bonds were the risk-free-rate from which all risks were priced. In the last decade markets have changed. The bond market is increasingly hollow and thin. The reality is few folk outside bonds pay attention – central banks set bond rates. Good or bad thing?

What if they held a bond auction and nobody came?

When I was a lad, the quarterly US refinancing was an event of huge market import. We watched as around $30 bln of Bills, Notes, Bonds and the Long Bond, were auctioned into the market, while we fretted about what the cover and the tail between high and low bids meant for markets. $30 bln.. swoon! Where was the capacity to absorb it all? We had good and bad auctions, and as the US debt clock spun ever faster we constantly wondered if demand might become saturated.

We knew bonds were important. The brightest and best in the financial markets went into bond trading. (I was too stupid… I became a banker, a bond originator, a glorified salesman looking for firms, banks and government who wanted to borrow money.) The 10-year T-Bond rate set by the bond market consensus was, perhaps, the most important number to consider each morning. From the 10-year bond rate the relative price of risk across the whole market spectrum was effectively set.

But that was all so last millennium.

Today the US debt clock is spinning so fast it’s just a blur…  The big number is approaching $35 trillion, or $266k per taxpayer. There are some fascinating numbers on the page – like how the top 1% of Americans’ wealth is $19mm+, while the bottom 50% have less than $38,000. Or how health care costs in the US have tripled this century. I am trying to figure out how the US population is 336 million, but the number on the screen shows 590 million retirees? Really?

As I wrote US debt to GDP stood at 135.46%. It will already be higher.

Meanwhile, the Fed continues to manage our expectations as to when rates will finally be eased – clue, they won’t be to any significant degree. This is the new normalised interest rate reality – bond yields that reflect inflation, the economy, and demand for bonds. Quite rightly we worry about who will fund the US and buy its bonds. Yesterday’s US bond auction was a lacklustre affair. $70 bln of new 5-year notes slid at the open to 4.55% while $69 bln of 2-year notes failed to excite buyers much. No doubt the Treasury dealers will have been calling buyers for today’s 7-year – telling them yesterday’s bond sell off makes the market look cheap.

Maybe it isn’t.

Yesterday my chum Anthony Peters, a fellow “teenage scribbler”, wrote about how the bond market may be broken, citing US writer Lyn Alden’s Dumb Money newsletter: “The structure and size of the market is such that intelligent bond traders are not the primary movers of the market anymore. As a result, the informational value that we can get from the bond market is now greatly diminished..”

There are plenty of reasons to worry about bonds. These include the lack of liquidity that followed regulators effectively telling banks to de-risk trading and market making in the wake of the collapse of Lehman, the increasing power and influence of trackers and automated trading, and the market’s lack of depth as the headlines exclusively focus on Nvidia, Nvidia and Nvidia. Primary dealerships are a thin facsimile of what they once were. Central banks are trying to improve liquidity by engaging in “liability management” exercises to replace illiquid older debt issues with more liquid easy to trade bonds.

The core of the bond market’s relevance is the concept of the risk-free-rate: what the rate of interest on the benchmark government bond tells us about the market. Because financial sovereign nations can’t default – they just print more money to repay debt (which will have massive consequences on inflation and the currency if done badly) – the key to the bond market is that the risk-free rate provides a benchmark from which every other risk is priced off.

There is much the bond market can tell us – if it’s operating properly. That includes how an inverse yield curve spells recession or somesuch, but also how it should impact the price of equity and corporate credit as these are both demonstrably higher risks. Yet, in today’s market there seems to be little interpolation between the price of treasury risk, higher equity risks and the enormous risks of highly over-levered junk bonds. No one seems to be paying much attention to the relevance of the risk free rate?

Why?

Could it be because its no longer trusted, understood or considered relevant? Think about it. Over the QE period the risk-free rate was distorted downwards by QE and Zero Interest Rates by Central Banks. As the bond yield was no longer set by the market consensus on risk, but by central bankers deciding the economy need ultra-low rates, the risk-free rate became a quaint concept rather than the reality it once was.  That has been the case since 2009 – and although that’s only 15 years ago, I guess anyone under 40 in financial markets (at least 50% of the game) learnt their trade in that distorted environment.

I’ve spent my oh-too-long career in the bond markets, secure in my knowledge that in bonds there was truth, and a sustainable bond market is critical for successful economies. To figure out that relationship between the bond market and risk is effectively broken is a bit of a shock.

QE distortions, and the apparent disinterest of markets to understand them, have been at the forefront of my thinking for the last decade. My thesis is the speculative froth that mispriced risk created through the QE decade is still coursing through the market’s veins. I recently gave a talk which I then condensed into “The Economic Consequences of The QE Era” which sort of sums it up.

One key aspect is that since 2009 central banks have effectively controlled the price of debt – not the market. There were some fascinating comments from ECB executive board member Isabel Schnabel yesterday in Tokyo on how central banks might use QE in the future. Give her credit – she admitted QE has had significant costs and consequences. “[It] can be a powerful tool when financial markets are in turmoil….. Outside these periods, however, central banks need to carefully assess whether the benefits outweigh the costs.”

Schnabel went on to describe how QE may be used in the future in a more “targeted and parsimonious” manner, allowing central banks to intervene “forcefully when needed, but stopping them faster”. She cited the way the Bank of England intervened during the Trusster*uck, when the Prime Minister and her Chancellor’s blithe naivety triggered the LDI crisis in the Gilts market. Swift action by the BoE restored stability – and elevated the Governor onto Truss’s sh*t list.

Sounds great, but effectively what she said is Central Banks, not the market, will determine interest rates… whenever they choose to do so. Putting short-term QE policies in place to compensate for the growing liquidity gap in bond markets raises a host of potential consequences. Not the least is the moral hazard issue: If bond investors know central banks are prepared to step in during crisis – what holds back investors from deliberate stupidity when they know central banks will stabilise instability with lower rates?

There is more to be figured out here… I must find some time to do some thinking and if any readers have perspectives on how to restore the omnipotence of markets in bonds… please discuss..

Out of time and back to the day job…

Bill Blain

Author of The Morning Porridge

Wind Shift Capital

www.windshift.capital