EC The Looming Shortage In Government Bonds

The Phenomenon of Negative Interest Rates

One does not have to look any further than the exploding market for negative interest rate bonds to find convincing  proof of a bond shortage. Today negative interest rate  bonds total over $US12 trillion in Europe and Japan ( Chart 2). More importantly, the average duration of these bonds has increased remarkably just within the past year.  Negative yields extend out to 10+ years in Germany, 15 years in Japan and even as far as 30 years in Switzerland.

Not surprisingly, central banks themselves are having trouble finding all the bonds they need. For example, the ECB  is not permitted to buy bonds with a yield lower than its deposit rate of minus 0.4 percent, thus excluding many billions of euro-dominated bonds issued by Switzerland, Germany, France, Netherlands and Sweden. In other words, there is a real squeeze on positive-yielding safe haven bonds.  

Vanishing Credit Quality and Liquidity  

Since the emergence of the debt crisis in Europe starting in 2012, there has been a wave of national debt downgrades. Bank of America Merrill Lynch estimates that the share of bonds with the three highest credit ratings has dropped to 51 percent of all debt tracked by the bank’s world sovereign bond index, from 84 percent in 2011. With so many institutions restricted from purchasing anything less than high quality bonds, managers are facing a smaller and smaller market in which to participate. Creditworthiness comes into play in the very large repo loan market where high quality debt is used as short term collateral by hedge funds, money markets, private equity and other lending groups. It is estimated that the volume of repo loans using Treasury debt has nearly halved since the financial crisis of 2008. 

On the issue of liquidity, there have been system-wide reductions, even in the case of the US Treasury market, considered to the most liquid of all bond markets. Regulatory changes post-2008 have made bond dealers less willing to hold inventory and facilitate trades. Bond trading desks have slashed inventories in response to regulations such as Basel III and the Volcker Rule. Hence, primary dealers have reduced their U.S. debt holdings by as much as 80 percent according to estimates. 

These liquidity developments have prompted Barry Eichengreen of UC Berkeley to  argue that "international liquidity has plummeted from nearly 60 percent of global GDP in 2009 to barely 30 percent today." Recent auctions for US Treasuries feature large oversubscriptions, and this has driven yields lower. There is more than just a temporary flight to safety to quality debt; there appears to be a major shift in asset preference in favor of high-quality debt issued by the US and other major countries at a time when the supply of that debt is not keeping with demand.

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Doug Wakefield 3 years ago Contributor's comment

In March 2015, the JP Morgan annual stockholder report discussed the shrinking of Treasuries in ciruclation since 2007 even though the supply worldwide had expanded greatly. The evidence supported what you are talking about here. Central banks, sovereign wealth funds, etc, had been buying up US Treasuries and other Tier one assets (Basel III), while the supply at the dealer level had been shrinking dramatically. Your article only reinforces what I told my readers last year, and makes perfect sense. This is going to produce a huge shock to those holding heavy stock allocation with the mindset that higher stock prices mean MORE liquid assets, when development in US Treasuries since 2007 makes it clear this is not the case. Excellent article.

Gary Anderson 3 years ago Contributor's comment

Thank you for confirming what few believe, but is most likely true. And shortages could increase if policy is established to weaken price and boost yields. It is a diabolical bond first world we live in. Bonds as collateral are going to be in increasingly short supply if we are to believe people who are in a position to know.