Blain’s Morning Porridge – August 31st 2021: Bonds Tell Truth, but the Market is Broken
“Anyone who claims to know the future of interest rates is certifiable.”
This morning: The great Autumnal Bond Funding Season is upon us, but the looming taper of Central Bank Asset Purchase Schemes could well expose just how broken and dysfunctional bond markets have become. Markets always over-react to stress and panics, but when markets struggle with price discovery and liquidity, the coming sell off could be magnified, which means a great buying opportunity in bonds may be coming!
There is lots to worry about this morning – the consequences of the Afghan Skedaddle on perceptions of the US, the inflation threats central banks wish us to believe are “transitory”, Hurricane Ida’s trail of insurance claims, the rising backlash against ESG, and the apparent emergence of a new SuperCovid variant that’s more infectious…
Instead.. this morning let’s think about the bond market, because in the bond market there is always truth… It’s still August (for a few more hours at least) but today marks the start of the 2021 Bond Market Autumn Steeplechase. With bond yields still falling despite taper talk and record stock market levels – it promises to be a fascinating season.
The September funding Boom is a traditional feature of the Eurobond market year. It’s when all the banks and bankers realise year-end is approaching and get desperate for fees from business closed, pushing their capabilities by being seen to do deals and rise up the league tables. Smart corporate treasurers will be dangling mandates for deals in front of their bankers – knowing this is the best time to get the finest and tightest terms because this when their bankers are most desperate. The result is we’ll see a deluge of new bond supply.
Normally, the funding orgy lasts a couple of weeks before investors start to gag on a succession of too tightly priced deals that widen soon after launch. But, hey-ho, pricing doesn’t matter because Central Banks are all out there buying corporate bonds as part of their QE Asset-Buying Programmes. So… it’s possible to sell just about anything…
This year corporate treasurers know the Taper is coming – that’s what Jerome Powell confirmed last week at Jackson Hole – so they will be even more enthusiastic to get their deals done ahead of the stable-door to cheap financing slamming shut.
And bankers? Well they remember what happened last time the Fed tried to taper its monetary experimentation – a panic and closed market, therefore its even more important to get deals done now.. done ahead of any market unpleasantness..
The Corporate Bond markets are anything but perfect. There are massive underlying problems as banks don’t support deals, the secondary market is “by appointment only” via brokers, small investors (ie anyone with less than a couple of hundred billion Assets Under Management) can’t get allocations of new deals, much of the market is now in ETFs, yet things could get even less functional.
I suspect this year’s funding steeplechase and the coming Central Bank Taper is going to expose a fundamentally broken market. Liquidity is dry and the price discovery mechanism is busted. I was recently fortunate to be shown some confidential numbers on European Government Bond market liquidity. Strip out the asset-purchase activities of the ECB buying bonds, and the numbers show the Bund, OAT and other European markets have seem volumes plummet in recent years.
The flows in fixed income markets were once circular – investors could buy and sell via market making banks who would set the price based on demand and supply, the orders they were seeing from their universe of clients. It worked. Now it doesn’t. Now, rather than bond holders calling a couple of banks to get the best price, there is no market making anymore. Central banks set the price of bonds. When they aren’t their buying – who will?
As banks don’t trade as market makers, there is no longer a price-setting mechanism – when the central banks stop posting bids, there is no-one to replace them. The result is likely to be a massive liquidity block on even the hint of Central Banks tapering their asset purchases… and that spells… Opportunity.
When markets panic they over-react every time. When markets seize up – as I expect they will when the Taper becomes real – we’re likely to see massive over-compensation in bond markets, and by extension, in equity markets also. I suspect the coming bond market wobbles could prove to be something of a buying window.
Why? A small hint of taper will expose the broken mechanisms of the bond market in terms of price discovery and market making, but we also know Central Banks are unlikely to allow wild rises in interest rates. Since a bond price is a reflection of the likelihood the bond issuer is going to repay, and interest rates will be unlikely to change much… then a sell off becomes an opportunity to invest at a much more attractive yield when the interest-rate environment has barely changed.
But risk will have changed – a bond market sell off will trigger a crisis of confidence across markets changing perceptions and appetite for risk, which again is an opportunity for the wise to generate cheap cost opportunities.
The problem is… much of the bond market is under 35 and has never seen the conditions that caused the crisis back in 2008. On the other hand, and talking my own book….. some of us have weather several bond market crashes… we’ve done it before, and know nothing really changes about the ways in which markets panic!
When the crisis comes… well you know my email and phone number!
A diversion – Edinburgh
I’ve just spent the last few days up in Edinburgh, my home town and capital of the People’s Democratic Not-quite-a-Republic-Yet of Scotland. I was home for a family funeral celebrating a much-loved life lived full and well. Edinburgh is one of the world’s truly great cities – it isn’t big and brash like NY, particularly diverse or cosmopolitan in the manner of London, sophisticated like Paris pretends to be, but it is truly beautiful and superior in a smugly quiet way than only Edinburgh can do.
The town is an intriguing mix of old and new. The imposing Castle, (the most besieged fortress in history) caps the Royal Mile of 15th century buildings running down to Holyrood where our not-quite-a-parliament is based at the foot of our own mini-mountain, an extinct volcano. Despite being so small Edinburgh is one of Europe’s leading financial centres with a skilled cadre of lawyers, accountants, financiers and investment managers driving some superb businesses. (It’s fair to note Scotland’s other big city to the West is Glasgow, the denizens of which describe Edinburgh as: “fur coat and nae knickers…”)
If I was setting up a new financial business today in the wake of COVID and the ease of telecommuting – Edinburgh would be my first choice.. Except…
Why does Edinburgh’s notorious City Council seem so determined to destroy their city?
My home city feels like it’s on the verge of a coronary caused by blocked arteries – a very Scottish way to die. You can’t drive anywhere. Every single major road is clogged with empty cycle lanes – which few folk use because it’s a very hilly city. If it’s not a cycle lane, it’s a bus lane, or the road is simply closed for whatever reason the council picks that way. The easy way to get rich in Edinburgh is to open a road construction and repair company.
A few years ago the City fathers decided to build the world’s least cost effective urban tram system. The economists looked at it and concluded it would be cheaper and more efficient to simply buy brand new electric buses every 3 years, guarantee passengers a bus every 5 minutes on any route, and make the whole service free for 20 years as a less costly option than the tram.
Yet, the tram got built at enormous cost and trouble. It was hailed as environmentally friendly, blah, blah, blah. It goes from the town centre to the airport, and nobody really uses it. Now they are again ripping out the heart of the City to extend it further down to the Port of Leith so that more people won’t bother using it. I’ve used it once to get from Murrayfield to the pub after a Rugby match: it was a choice of a 20 minute walk or a 15 minute tram ride. I was curious.
Five Things To Read Today
BBerg – How Angela Merkel Turned Back the Clock of German History
FT – DWS probes spark fears of greenwashing claims across investment industry
FT – Price Discovery in markets not imperilled by index funds
BBerg – French Inflation Hits Highest Level in Almost Three Years
Torygraph – Beware Boris: Britain is hurtling towards a winter of discontent
Out of time, and back to the day job…
Strategist, Shard Capital
Are you convinced central banks are really going to taper? Or rather taper to the extent that the bond market would break down? Default mode seems to be QE forever and I can’t see why the CBs would commit to a course of policy normalisation if it would rattle markets. Mandates be damned, a crisis delayed is better than a crisis suffered one’s watch. Central bankers aren’t automatons which is why I struggle to see why Powell would commit to taper before he’s reconfirmed (if he is) which means any taper announcement would be pushed back to early next year. Is this a buying opportunity that may never arrive, at least until there’s a real blowup?
Ah, the rotten ‘burgh!
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