The Great Sovereign Debt Intervention Is Here
Monetary leaders possess an expansive toolbox to prevent a bond market meltdown
Bond markets have been growing increasingly unstable lately, causing many to warn about a possible “sovereign debt crisis” unfolding. But monetary leaders now possess numerous mechanisms to prevent a catastrophe. The Great Sovereign Debt Intervention™ is upon us.
Tasked with preventing sky-high inflation mostly caused by issues beyond their control, Federal Reserve officials have been forced into raising rates sharply to lower prices near their — highly controversial — 2% target. This will indeed cause significant pain worldwide. Rising interest rate differentials will spur a stronger U.S dollar, affecting the 50% of transactions invoiced in Greenbacks globally. The Fed’s gambit is to fight inflation, hopefully without “blowing up” other countries through a rising Dollar, a currency already in scarce reserve.
Many commentators deem rate hikes to be the worst solution to what has been a crisis of supply. But political objectives have guaranteed that dollar fatalism will be enforced to battle rising prices. For now, the “dollar milkshake wrecking ball” will keep crushing prosperity worldwide.
With the potential for another 2% in rate hikes by March 2023, and inflationary pressures continuing to build, further Treasury market turmoil is about to unfold.
Just this week, bond yields have risen to levels not seen since the failure of Lehman Brothers. The expansionary impulse of trillions in stimulus, plus the sharpest rate hiking cycle in decades, has caused significant dumping of Treasuries. While yields have risen because of the market’s perception of inflation, growth, and interest rates, rising volatility has exposed structural weaknesses, exacerbating a selloff. America continues to issue twice the amount of bonds per year compared to pre-COVID levels, into increasingly illiquid conditions.
Concoda’s “illiquidity spiral” (the doom loop of volatility creating illiquidity, which creates more volatility, and so on) seems to be playing out, wreaking havoc in America’s sovereign bond market.
Increased volatility, diminished liquidity, and declining market depth means further instability is assured, which will likely send bond yields even higher. Eventually, monetary officials must intervene, and with intervention comes monetary alchemy. Central planners now have an abundance of mechanisms to prevent (what some assume to be) a sovereign debt bubble from bursting.
With numerous tools in hand, however, officials will only resort to full-on yield curve control as a last-ditch attempt to rescue Treasury markets. Instead, at the earliest indication that illiquidity is becoming hazardous, the U.S Treasury will respond with a different solution: buybacks. Using funds from either bond sales or its bank account at the Fed, the U.S Treasury will repurchase bonds in the secondary market (via primary dealers such as JPMorgan and Nomura) to improve liquidity and suppress yields. Higher bond prices equal lower yields and fewer expenses. Buybacks also earn America the added bonus of reducing interest payments on its outstanding debt:
Previously, Treasury buybacks have been an effective tool for suppressing bond volatility, yet they are unlikely to dampen today’s record-high levels.
Officials will have to fire up their next mechanism: indirectly incentivizing large financial players to purchase more Treasuries.
This, however, is harder than it sounds. Ever since the Great Financial Crisis (GFC) in 2008, banks have become “balance sheet constrained,” a fancy way of saying regulation has prevented financial entities from taking on too much risk in certain situations (like buying a truckload of Treasuries), even if it’s beneficial to the system.
In the GFC’s aftermath, the Bank for International Settlements (BIS), the self-described “central bank for central banks”, introduced its third round of rules: the Basel III Accords. This set out a plethora of rules and regulations, aimed at preventing future crises.
Regulators had taken a hard line against fraud-ridden bubbles like the subprime MBS boom of 2007/2008. Subsequently, banks have had to retain a lot more capital relative to their assets (a higher “capital ratio”) to comply with regulations.
They also had to retain enough “high-quality assets,” known as HQLA, which included such assets as bank reserves and Treasuries, to meet their Liquidity Coverage Ratio (LCR). This regulation has required financial institutions to hold 30 days’ worth of HQLA assets, so they can handle customer outflows during crises:
Still, with this large safety net, big players have not been buying enough bonds to foster normal levels of volatility in Treasury markets. But that’s about to change. When bond market chaos ensues, monetary officials will modify another rule: the SLR (Supplementary Leverage Ratio).
The SLR directs banks to hold around 3-5% capital against “unweighted assets”, meaning even risk-free interbank reserves and Treasuries are deemed just as dangerous as risky investments, like mortgage-backed securities (MBS).
This was a reaction to the events of the financial crisis. During the subprime bubble, MBS securities were deemed so safe that banks couldn’t imagine a scenario where they went to zero. What’s more, banks believed they’d taken out risk-free credit default swaps (CDS) against MBS, which would hedge them against a financial catastrophe. But as we found out, safe assets can become tainted. Both MBS and CDS needed a bailout. Not too long ago during COVID, even the Treasury market lay on the brink of a meltdown before authorities intervened. In reaction to the subprime crisis, however, banks had to implement SLR, creating bizarre incentives.
The SLR, along with other regulations in the Basel III Accords, increased the financial system’s peculiarities. Since it prevents bank balance sheets from becoming too large, banks must now maximize returns on a smaller portfolio of assets, ditching low-yielding investments that curb their profitability, one of those being Treasuries.
COVID briefly changed this dynamic. One month after the March 2020 crash, trillions of government debt had entered the system. Banks were given “SLR relief” and were authorized to hold more Treasuries and reserves without incurring regulatory penalties. After the crisis turned into calm, regulators removed SLR relief in March 2021. Banks dumped their Treasuries en masse, as it hindered their profitability once again.
So when Treasury buybacks prove ineffective, authorities could entice big players to gorge on a larger number of Treasuries (instead of being mere middlemen). Multiple bureaucracies, from the FDIC to the OCC, must sign off to provide “SLR relief.” But in a panic, there will be no indecision.
Freed from the constraints of SLR, large banks will be able to absorb a larger number of bonds at no cost to their regulatory ratios. But they must be willing to buy. If they aren’t enticed, authorities must increase the temptation.
Before going into full-on “yield curve control mode”, the Fed will try imposing a “soft ceiling”, announcing they’ll temporarily buy a certain amount of Treasuries at a set rate. Market players will likely join in, and Treasury volatility will wane. Or, so you’d think.
In the last few months, an alternate prophecy has emerged in mainstream financial circles. Prominent thinkers have predicted that inflation could persist even after every major supply issue has been resolved. That could mean higher (bond yields) for longer.
They argue that since global demographics and globalization have peaked, the subsequent impacts will cause a structural shift toward persistent inflation. They say deflation in Japan was an anomaly, caused by the disinflationary force of China joining the global U.S order.
Now that China’s growth model has peaked, among other catalysts, inflation could stick around longer than any policymaker anticipates. They could be caught off-guard by long-term structural forces. Monetary leaders are well aware of how bonds act in the current paradigm, but now they must consider what might happen if inflation is far from transitory.
If the contrarian prediction comes true, Concoda predicts authorities will try to cling to the status quo of lower yields for as long as possible. In response, they will utilize a new set of tools to maintain lower bond yields in a persistently inflationary environment.
Fed officials will eventually start to utilize their most powerful tool: yield curve control, imposing an “upper bound”. With the ability to create infinite amounts of money in the form of bank reserves, the Fed can buy as many bonds as they need to suppress yields.
Though this will limit the amount of interest the U.S government pays on its debts, it will not quell inflation. And if measures outside rate hikes don’t manage to control rising prices, the Fed’s upper bound could be met with serious opposition.
It’s unlikely to reach such a situation, but if so the U.S could then mandate citizens to buy government bonds, reducing pressure on the so-called upper bound. More importantly, however, the Fed will avoid directly purchasing bonds from the U.S Treasury — which is currently illegal under the Federal Reserve Act to protect its independence and curb direct political interference.
With most citizens wanting stability, not calamity, most will oblige, bearing the burden of what will likely become highly negative (real) yielding assets.
If they aren’t tempted, the persuasion toolbox for incentivizing bond buying can always expand. The U.S government could introduce measures such as increasing rent controls to discourage real estate investment, raising taxes on stock purchases, and even curbing the ability of U.S citizens to invest abroad.
Monetary and fiscal alchemy will be pushed to new limits. Though, as Concoda has stated before, we won’t even come close to a U.S “sovereign debt collapse” that many have warned about for decades.
Nor will we see the largely touted “debt jubilee”. History does show ancient rulers canceling debt when it created too much social tension and low productivity. But since pensions now hold so many sovereign bonds, debt cancelation would pose a global systemic threat. In an interconnected financial world, debt jubilees simply aren’t achievable.
It’s important to point out that many nations are carrying out a quasi-debt jubilee. Central banks such as the Fed and BoJ have been acquiring bonds on their balance sheets, turning their sovereign debt into interest-free loans that never need repaying. When these bonds mature, central banks take the principal they receive and buy newly-issued Treasuries from the secondary market, while they send interest payments right back to the Treasury during the bond’s tenor, creating a perpetual interest-free loan.
Japan has already been canceling around half of its debt and will eliminate roughly ¥90 trillion more each year. The U.S, meanwhile, is paying off around a quarter of its liabilities, free of charge. For the U.S at least, this is changing as we speak. With Quantitative Tightening (QT) underway, the Fed is forcing citizens (who won’t want to offer the government an interest-free perpetual loan) to fund more of America’s future debt load. QT is transferring ownership of bonds from the Fed to the private sector, demanding more public trust to fund the U.S government.
The fact that the Federal Reserve, hence the U.S government, is now willing to take on less responsibility for rolling over U.S debt shows monetary officials are far from entering panic mode. They are hoping the skeptics are proven wrong, once again.
If not, the endgame for America’s Great Sovereign Debt Intervention™ will likely be permanent support from the Federal Reserve. At whatever cost, bond market stability will be achieved, making today’s policies seem normal.
For other nations, however, their bond markets might not be so lucky.
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