For years, but particularly since the COVID-19 pandemic erupted in March 2020, central banks have effectively backstopped government spending, mopping up a significant proportion of the debt hitting markets and preventing yields from rising too high.
But if central banks set a schedule for unwinding pandemic-era stimulus, a dearth of highly-rated bonds, especially in Europe, may turn into an excess.
JPMorgan estimates central bank bond demand across the United States, Britain, Japan and the euro zone will drop by $2 trillion in 2022 following a $1.7 trillion reduction this year.
It expects U.S., German and British 10-year yields to rise 75, 45 and 55 basis points respectively by end-2022, although it did not specify the impact of supply on bonds.
Globally, JPMorgan predicts central banks will lead a roughly $3 trillion drop in bond buying, translating into an average yield rise of 20-25 basis points.
“I am not suggesting next year is going to be bond Armageddon – but you’ve got a period where inflation is still stubbornly high, central banks are behind the curve in terms of raising interest rates, and at the same time you’ve got large net supply,” said Craig Inches, head of rates and cash at Royal London Asset Management.
“That’s quite a heady mix for bond markets.”
The U.S. Federal Reserve will end the phase-out of its $120 billion monthly purchases in March. The Bank of England’s 895 billion pound ($1.18 trillion) bond-buying scheme ends this month, while the European Central Bank’s 1.85 trillion euro ($2.09 trln) Pandemic Emergency Purchase Programme (PEPP) will expire in March.
Central banks won’t vanish from markets. To compensate for withdrawing PEPP, the ECB will temporarily double existing monthly stimulus to 40 billion euros, while it, the Fed and the BoE will continue ploughing proceeds from maturing bonds back into markets.
Overall though, the impact is negative.
Britain could be the market most affected. ING estimates that private investors will have to absorb a net 110 billion pounds of gilts in 2022 versus 14 billion pounds this year, given 2021’s BoE bond purchases of almost 170 billion pounds.
What’s more, the BoE plans to stop reinvesting proceeds of maturing debt once interest rates reach 0.5%, a level that’s possible by mid-2022. Once rates hit 1%, it may consider selling off the bonds it owns.
Gross UK government borrowing plans imply an average 120 billion pounds in annual net issuance over the next four years, levels not seen since 2011, says RLAM’s Inches. He expects 10-year yields to double by end-2022 from roughly 0.75% now. (Graphic: British gilt yields over a two-year period, https://fingfx.thomsonreuters.com/gfx/mkt/zdvxoxjwbpx/gilts1412.PNG)
It’s a stark contrast with a year ago when central banks were cranking up the printing presses.
In the euro zone, yield premiums may rise 20-30 bps, according to Ralf Preusser, global head of rates research at BofA.
If markets are correct in pricing a complete end to asset purchases next year, “the rate shock becomes even bigger and risks being a very significant chunk of positive net issuance that we would need to absorb for the first time since the European sovereign (debt) crisis,” Preusser said.
“Spreads in Europe are not priced for that,” he added. (Graphic: Supply outlook from BofA, https://fingfx.thomsonreuters.com/gfx/mkt/gkvlglqzzpb/SupplyBofA1412.PNG)
France looks especially vulnerable; it pays a meagre 35 bps yield premium over Germany, less than a quarter of Italy’s, yet according to Unicredit it will have the largest volume of debt not covered by ECB purchases. It estimates net issuance at around 120 billion euros in 2022.
Overall euro supply, including European Union bonds, will be the highest since 2015 at 157 billion euros, BNP Paribas’ head of strategy for G10 rates, Europe, Camille de Courcel said.
“The net supply picture is changing dramatically next year amid a strong deceleration of (central bank) purchases, and in light of the fact that gross supply will still remain relatively elevated,” she said. (Graphic: Estimated ECB purchases versus net market issuance, https://fingfx.thomsonreuters.com/gfx/mkt/movanqbzrpa/SupplyUniCredit%201412.PNG)
U.S. supply may be lighter.
ING analysts say the wind-down of Fed purchases amounting to $1 trillion annualised will be offset by a $1.5 trillion drop in Treasury net issuance. That means “overall net supply pressure will shrink by some $0.5 trillion”, they told clients.
With perennial overseas demand for Treasuries, that should cap 10-year yields – a Reuters poll sees end-2022 levels of 2.08% while most banks expect around 2.25%. That is around 85 bps higher than now, notwithstanding a Fed taper and three likely rate hikes.
(Reporting by Dhara Ranasinghe; additional reporting by Sujata Rao in London and Stefano Rebaudo in Milan; Editing by Sujata Rao and Catherine Evans)