Bond vigilantes are poised to wrest back power in 2018. For the first time in four years, the U.S., Japanese, euro zone and UK governments will together issue more net debt than their central banks will buy. That gives investors a welcome chance to hold profligates to account. But markets may be prone to over-reaction as money managers rediscover their rusty powers of discernment.
Combined net debt issuance by these so-called G4 economies will total $1.3 trillion, up by a third from the projected issuance for 2017, according to Morgan Stanley. The increase in supply will coincide with a decline in demand from central banks, which are expected to reduce their combined bond purchases. That makes for a watershed year in which net issuance will exceed official purchases of debt.
Bond prices will respond. In the past couple of years, buying by central bankers dwarfed issuance, on a net basis, and drove down yields, sometimes into negative territory. About 43 percent of outstanding European government bonds and 60 percent of Japanese ones were yielding less than zero at the end of October, according to Tradeweb.
Investors who wanted better returns have been forced to buy longer-dated or riskier debt, and venture into other markets. Liquid assets, such as equities, were bid up by what Citi analysts dubbed bond "refugees". So were illiquid alternatives such as infrastructure and private equity funds. As the balance between the supply and official purchases of government debt flips, investors may return to their natural comfort zone.
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If all goes well, that shift will be gradual and bond yields will rebound slowly. That's not a given. Say corporate defaults were to rise markedly. Authorities have dampened sensitivity to these risks for so long that investors may over-react when confronted with them. Price swings will be further amplified if asset managers find themselves stuck in illiquid markets during a broader sell-off. Those who cannot bail out of their riskiest holdings may be forced to sell less risky but more liquid bonds.
Bond prices have been getting less volatile for several years. When valuations are less driven by central banks, that will no longer be the case. A necessary shift, to be sure, but one likely to create some unsettling market moves.
This is a Breakingviews prediction for 2018. To see more Breakingviews commentary, click here.