Australian Bonds: Dead Canary or Global Dog Wagger?

Australian Bonds: Dead Canary or Global Dog Wagger?

Two weeks ago, I asked you, ‘Is Australia the dead canary in the global bond market?’. Since then, it’s been raining dead birds in bond markets all over the English-speaking world.

Canada, the UK, and the US have all seen odd goings-on in their bonds, which wreaked havoc on mortgages, currencies, and, of course, bonds themselves.

But first, a quick reminder: Why does the bond market matter at all? Well, bond markets are far more important than stocks for a long list of reasons, not just their greater size.

Governments finance themselves with bonds. If the interest they must pay increases, taxpayers are paying for that interest instead of government services. And if bonds crash, governments might not be able to finance themselves at all, let alone their existing debt repayments.

Companies are the same — they use bonds to finance themselves. And when they go bust, it’s the bond market that drives them over the edge. Higher interest rates raise the risk of this occurring or just hurt profitability.

Mortgages are directly or indirectly tied to bond markets too. As UK and Australian borrowers found out the hard way recently. More on that below.

Central banks use the bond market to impose their monetary policy. It’s where most of the famous quantitative easing takes place, for example.

Currencies’ values are partly determined by the return investors can earn by holding those currencies, which is easiest to pinpoint by the local interest rate that is set in the bond market.

And a huge swathe of our superannuation wealth is invested in bonds, even if we’re not aware of it. Not to mention the vast holdings of the likes of banks and insurance companies.

Perhaps most importantly of all is one of the few useful things you can learn about at university…

Just about any financial equation you can find will have the ‘risk-free rate’ built into it. This is the return that investors can get from a mythical risk-free investment. All other investment prices are determined by their relative offering of risk and return above this risk-free rate.

When it comes to actual data to plug into your equation, government bonds are the short-hand place to look for the risk-free rate, because governments with printing presses don’t default on their debt.

All of this is a long-winded way of saying that, when bond markets move, the valuation of all financial assets are in effect shifted too. It’s a bit like an earthquake in financial markets.

So chaos in the bond market would mean chaos just about everywhere else in our lives. The thing is, that’s no longer a hypothetical…

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UK and Australian mortgage borrowers already know how much the bond market’s machinations can hurt. The UK’s Telegraph reports, ‘Homeowners suffer soaring mortgage costs — but banks leave savings rates at record lows’ and ‘No savings accounts beat inflation’.

What actually triggered the recent shift in UK bond markets and banks is especially fascinating.

Over the past few months, the Bank of England governor had repeatedly warned about raising interest rates to rein in inflation. But when the time came, the anticipated rate hike didn’t materialise. This surprise, like the Australian one before it, caused quite a bit of havoc, and not just in the UK bond market.

The Financial Times reported on the consequences:

‘[Pound] Sterling fell 1.5 per cent to $1.352 after the announcement, its weakest level against the US dollar in five weeks. Short-term UK government [debt] staged its biggest one-day rally since March last year, pushing the two-year bond yield 0.21 percentage points lower to 0.48 per cent.

We’ll focus back on bonds in a moment, but first, consider the reaction in the UK’s tabloid paper the Daily Mail:

Is the Bank of England Governor who cried wolf over interest rates the right man for the job? MPs and City figures voice concerns as inflation storm clouds gather.

Critics questioned whether he was the right man to lead the Bank after a “big communications failure” on interest rates prompted lenders to raise mortgage costs unnecessarily.

So in case you were unimpressed by the bond market’s moves, the tumult it caused was enough to make people question whether the right man is in the job at the Bank of England.

But notice that ‘raise mortgage costs unnecessarily’. Banks got away with raising interest rates when the central bank didn’t, and the bond market’s yields actually fell. That’s not ideal unless you’re a banker.

But focus on the turmoil, as opposed to the direction of bonds. Bloomberg’s discussion of the market drama focused on the financial sector’s perception:

Investors are blaming the Bank of England for creating the very conditions it blamed for its communication flip-flop this week.

“A deterioration in liquidity conditions meant that it had become more difficult to infer a central path for policy expectations,” Monetary Policy Committee members said in minutes from the decision on Thursday. But that illiquidity was a result of uncertainty over the BOE’s own policy position, analysts said.

In other words, the Bank of England argued that financial markets were only surprised about the lack of an interest rate hike because not enough people were betting on whether one would happen or not. But those doing the betting point to the confusion from the Bank of England as the reason why nobody was betting on the moves.

Bloomberg continues:

The central bank’s decision to keep interest rates on hold sent gilt yields and the pound sharply lower. It came just two weeks after Governor Andrew Bailey said we “have to act” on quickening inflation, cementing investors positioning for a rate hike.

“The cause of the market illiquidity was poor communication, which meant that they could not accurately infer market expectations,” said Peter Chatwell, head of multi-asset strategy at Mizuho International Plc.

“I would suggest a thorough review of the communications policy is overdue and is something that would benefit the U.K. public,” he said. “After all, it is the tax payer and the U.K. real economy more generally, which suffers from the excess volatility that these difficulties have caused.”

Yes, someone must pay when there’s bond market volatility.

In another article, the Daily Mail described the response from the Bank of England to all this chaos:

Inflation will pick Britons’ pockets for two years: Bank of England governor APOLOGISES as he warns families will be “hit hard” this winter and will be almost 2% worse off by 2023 while higher energy prices could become permanent.

Andrew Bailey said he was “very sorry” as forecasts suggested inflation could spike as high as five percent.

So in the end, the UK was left with a devalued pound, higher mortgage rates, instability in the bond market, a bout of inflation, and an apology.

Good work, Bank of England.

All this shows how instability in the bond market can wreak havoc. After all, central banks seek to influence and control bond markets, not completely rule them…yet.

But the Bank of England’s governor is not the only one struggling with how to tighten monetary policy. Central bankers are in a real pickle over how to normalise their extreme policies of the last year…well, it’s been almost two years now. Or 12 years, you could say, given the 2008 crisis.

The action which the Bank of England unleashed in UK bonds, known as gilts, with its phantom rate hike quickly spread, as another Financial Times article explained:

The ensuing rally in the gilt market, as traders unwound their bets on UK rate rises, also jammed yields sharply lower on eurozone bonds and US Treasuries.

The episode highlights how a clutch of smaller central banks — most notably the BoE, but also the Bank of Canada and Reserve Bank of Australia — have recently found themselves in the unusual position of dictating moves across the world’s biggest bond markets.

“We’ve seen on a number of occasions now that these central banks that are usually on the fringes of global markets have been in the driving seat,” said Rabobank rates strategist Richard McGuire. “It’s definitely the tail wagging the dog.”

I think that’s wrong. Australia was the canary, not the dog wagger. It was a warning of what could happened elsewhere.

The latest bond market to take a hit is the US. This week, a poor auction for 30-year Treasury bonds sent yields spiking. In other words, when the US government tried to borrow money for 30 years, it had to offer an unexpectedly high rate of interest to entice investors to hand over their cash.

Now, although I disagree about Australia being the tail that wags the dog in the global bond market, there is in fact a tail wagging the dog in the US bond market. Indeed, it turns out that bond markets actually have tails. And it was the tail which blew out in the US bond market causing the turmoil there.

Although the definition is complex, the underlying idea of a bond auction ‘tail’ is the gap between where traders expected the bond auction to price at and where it did price at the auction. As mentioned above, the US government had to offer an unexpectedly high interest payment in order to sell its debt, which means the ‘tail’ measure came in higher than usual. And that’s an understatement.

DailyFX described how the tail exploded to 10 times its usual size, setting a record, and it went into the consequences too:

A weaker-than-expected auction of 30-year Treasury bonds saw a tail of 5.2 basis points, the largest on record for a 30-year auction. For context, the average tail over the last 6 months has been only 0.5 basis points.

The US Treasury sold $25 billion of 30-year securities at a high yield of 1.94%, compared to a pre-auction yield of 1.888%. The immediate spike in yields pushed the US Dollar higher, with the Greenback hitting fresh one-year highs above 98.84.

Again, a little turmoil in the bond market is causing trouble elsewhere.

What’s going on?

Well, it seems that bond traders are dramatically overestimating demand for bonds, and/or the yields at which investors are willing to buy bonds. But let’s dig a little deeper.

I disagree about the tail wagging the dog argument. Australia’s bond market isn’t making others move. Neither did the UK’s. Instead, this is about exposing how fragile bond markets are right now. That’s why the US bond market’s tail rose 10-fold from its usual level too.

If inflation is rising dramatically, for the first time in decades, that suggests tighter monetary policy is on the way. Which implies higher interest rates and therefore lower bond prices. Who wants to be invested in bonds when that’s on the cards? Less people than was presumed, apparently.

Australia’s drama really was a canary in the coalmine. And since then, Canada, the UK, and the US bonds have keeled over, too, exposing just how quickly things could go wrong elsewhere.

Who’s next? Because not every government out there is in a financial position that can withstand bond market surprises.

Until next time,

Nick Hubble Signature

Nickolai Hubble,
Editor, The Daily Reckoning Australia Weekend

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