Jan Dehn, head of Research at Ashmore, suggests that markets may eventually be relieved of their traditional roles of determining term yields. He cites Japan as the prime example of this risk materialising, and suggests that no market country is likely to handle the bear market steepening that would occur if markets were free to price bonds as inflation returns.
The risk is increasing that the market’s role in pricing government bonds in developed economies could be seriously curtailed or eliminated over the next few years. The reason is not that markets do not work, though in many cases that would be a valid criticism. Rather, the reason is that developed countries are likely to cope very badly with the yield curve bear steepening that would occur naturally if markets were free to price in future inflation, given high debt levels and low trend growth rates. Growth rates are simply too low, productivity rates too low, debt levels too high and asset prices too elevated for developed economies to handle the required steepening. Inflation is therefore not just a threat to returns, but could lead to measures that end trading altogether.
To those that think that this sounds alarmist, the elimination of bond markets in the developed world is already well underway. Japan’s recent decision to stabilise the 10-year government bond yield at zero – a policy euphemistically dubbed yield curve targeting – is indicative of things to come in other developed bond markets. Western economies are also a lot closer to killing off their bond markets than many appreciate.
The European Central Bank (ECB) has almost run out of room to buy bonds and the US Fed is already the single largest owner of US Treasuries and mortgages. Pension funds and insurance companies own huge chunks of government debt too, but they are severely restricted in their ability to off-load their holdings due to regulation. Basel II and III and Solvency II regulation forced enormous volumes of bonds onto those institutions.
Japan’s yield curve targeting policy is revolutionary, because it overturns a very, very long tradition in capitalist societies of tasking markets with determining long yields, a policy that has traditionally relegated solely the very shortest end of the curve to government control. This division of labour between markets and policy makers along duration lines already began to blur with the start of Quantitative Easing (QE). By shifting its de facto policy rate to the 10 year point on the government curve, the Bank of Japan has truly gone the extra mile by effectively eliminating the role of the market in setting term yields.
Looking ahead, it is easy to imagine that Japan’s approach – or an equivalent policy – could gain popularity in the rest of the developed world, because it confers considerable short term advantages upon governments. In comparison to US long bonds, Japanese long bonds have already proven to be more stable in the face of volatility than in the past, which is a quality that surely must seem desirable in countries with large debt stocks. One imagines, for example, that Japan’s policy has caused some European governments and ECB policy makers to sit up and listen as a means of defending against another European periphery debt crisis.
Nearly every developed market government is also gearing up for more fiscal spending, having exhausted the scope for monetary stimulus. The certainty that the central bank will buy any bond in order to keep yields at zero gives carte blanche to the Japanese Treasury to increase fiscal spending in the knowledge that yields are stable.
In addition, the Japanese policy has longer-term benefits that become evident after inflation returns in earnest. Each uptick in inflation will erode the real debt stock, but for the most part without any need to fear bond market vigilantes. Of course, bond holders will take losses, but the underlying investors in pension funds will not know they are being lulled into a false sense of security until they retire many years from now..
Governments have ways of controlling term yields other than the Japanese way. Central banks can engage in direct purchases of bonds in primary auctions to hold down yields, so-called Helicopter Money, and they can swap the existing bonds on their balance sheets into longer-dated securities at the same yield.
The same conditions don’t apply to EM
Whatever the method used the implication is the same: bonds will cease to be freely traded in markets and their real value will be steadily eroded over time.
The destruction of developed market bonds makes EM bonds more attractive as the only truly tradeable fixed income markets left in the world. At $18.5trn in size and extremely diversified, EM bonds are already attractively priced with bond yields sitting just 40bps below the yield they had in late 2006 when the Fed had rates at 5.25%.
More importantly, the conditions that are leading to the death of bond markets in rich countries are simply not in existence in EM. No EM country has anywhere near the combination of low growth rates and high debt levels that characterise developed countries.
No EM country has done QE. No EM country is ever granted the luxury of low or even negative yields. No EM country can rely on currency appreciation when they have a crisis. No EM countries can avoid reforms when the economy starts to fail. In other words, EM countries are always forced to deal with their problems head-on, which is why things never get as disastrous as they are in developed economies these days. Above all, most EM countries are in the process of developing their markets, not killing them. This bodes well for depth and breadth and diversification of the asset class over time.