At the beginning of this year, there was a lot of concern about whether the government bond markets could absorb the record amounts of debt being issued by sovereigns. As one banker told me: ‘Governments became the borrowers of last resort. If they hadn’t been able to access the market, it would have had a huge impact.’ Indeed, it would have meant we were in a genuine 1930s style financial collapse.
But luckily, despite a failed auction here and there, sovereigns were able to access the markets and to sell trillions in debt – Eurozone sovereigns sold €950bn this year, the UK £220bn, the US $1.9tn and so on. As Paul Spurin, head of government bond trading at RBS, and vice-chair of the European Primary Dealer Association, told me: “The market has been through the biggest stress test imaginable.”
Well, get ready for an even bigger test. Sovereign issuance is likely to be at the same levels next year – but this time, without the benefit of central banks buying up most of the debt.
This year, for example, the Bank of England has bought up three quarters of all Treasury issuance. The Fed has bought up a similar amount of US Treasuries. The ECB’s Quantitative Easing programme, it turns out, is not quite as big as I’ve suggested here before, but the ECB has still lent hundreds of billions to banks at 0.5% via its liquidity auctions.
Stuart McGregor, head of public sector syndication at Bank of America Merrill Lynch, says: “There’s no question that QE has helped considerably in getting auctions done. When that stops, it will become more difficult. Everyone assumes that for debt to be sold next year, sovereigns will have to pay higher yields.”
I interviewed Robert Stheeman, CEO of the UK’s debt management office, who says he is confident that the UK will be able to meet its borrowing demands next year – he points out that yields are still at historical lows – but he’s worried about an orderly transition from a QE environment to a post-QE environment. He says: “Any big buyer distorts the market. But as the Bank slows down and yields may move up, presumably our debt will be more attractive to other investors. My main concern is that any market adjustment happens in as smooth, orderly and frictionless way as possible.”
On the positive side, the appetite for government debt is quite big, partly because the $3tn securitisation market has more or less disappeared, so there’s a lot of demand for AAA debt, even if western central banks are no longer buying.
But traders say the risk is that central banks will wait too long to put up rates, and that inflation will suddenly pick up. If that happens, expect to see demand drop suddenly for long-term sovereign bonds, at the very moment that sovereigns are trying to borrow less in short-term debt and more in longer-term bonds.
We could be in for a bumpy few months in the sovereign debt market.
