Solvency Constraints

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The dollar rally may be set to continue as limits on quantitative tightening bind other central banks before it binds the Fed. The tail risks of QT have first appeared in the gilt market, where significant price volatility prompted official intervention. What appears to be a liquidity issue will ultimately become a financial stability issue as investors discover their “safe assets” are not safe. These concerns may prompt a policy response similar to that seen in Japan, where the price of sovereign debt is explicitly supported. Just as yield curve control led to significant Yen weakness, so a similar move by other central banks would also severely weaken their currencies. This post describes the link between bonds and financial stability, notes the existence of a central bank “put” on bonds, and suggests other central banks would likely cave first.

When “Safe Assets” are not Safe

A steady upwards march of sovereign yields would likely lead to financial instability by pushing some financial sector entities into insolvency. Global regulations post-GFC mandated many of these entities to hold sovereign debt as safe assets, but sovereign debt is actually not safe. They are free of default risk but can still suffer equity like price declines with volatility that approaches that of crypto. Recently, some investors in longer dated gilts were pushed dangerously close to insolvency and saved only by emergency central bank intervention. Note that losses from bonds can be redistributed through the financial system using hedges, but not eliminated.

Longer dated gilts have traded like meme stocks. Source: Bank of England

Financial crisis can arise when investors discover their safe assets are in fact not safe. The GFC arose in part because highly rated private label MBS securities that were considered safe were actually risky. The sudden repricing of those securities raised widespread solvency concerns that precipitated into a run on the financial system. Similarly, the European Sovereign Debt Crise arose in part because the debt of peripheral European sovereigns were considered safe when they were actually not. The repricing of peripheral debt raised solvency concerns of the European banking system and also led to a run on the financial system. The setup today appears similar, but this time may be different.

From Periphery to Core

Financial stability concerns will likely force all central banks to eventually support the bond prices of their respective sovereigns. Policymakers vividly remember the collapse of Lehman and will do whatever it takes to avoid a repeat. The prospect of a financial crisis led the BOE to immediately postpone QT and roll out unlimited bond buying, with the promise that the purchases are temporary. Their actions pumped up gilt prices and restored the solvency of some investors, but it is not clear if the price declines were merely due to illiquidity.

Market prices are ultimately determined by supply and demand, and these factors continue to suggest higher global yields. Central banks, who were large and price insensitive investors, are no longer buying. At the same time, net issuance in developed markets remains high from fiscal spending. The proximate causes of gilt market volatility was an anticipated surge in issuance to fund energy subsidies and tax cuts, as well as impending BOE gilt sales. But a similar event could easily take place in other markets. For example – central banks have been the overwhelming buyers of Spanish and Italian bonds but have now stepped back. The higher yields we see may be the market clearing prices and persist absent official intervention.

Central banks purchased almost all Spanish and Italian sovereign debt during the past few years. Source: Robin Brooks of the International Institute of Finance.

From Rates to FX

A central bank that rolls out support for its bond market is likely to see their currency depreciate. The potential policy options range from sterilized and limited QE to yield curve control, which is the policy of the BOJ. The result of YCC in Japan was tremendous Yen depreciation as investors moved out of Yen and into foreign currencies in pursuit of higher returns. That is the predictable outcome of any form of bond price support, which would mechanically widen interest rate differentials. The last jurisdiction to restart asset purchases would likely experience the most currency appreciation.

BOJ’s yield curve control prevented its bond yields from rising as global yields rose

The Fed is likely to be the last major central bank to backstop bond prices due to the relative strength of the U.S. financial system. After the BOJ and BOE, the ECB looks poised to be the next central bank forced to shore up its bond market. The financial sector is opaque, but market pricing and commentary appears to be indicating growing concerns over the health of European financial institutions. European banks and pension funds are large investors in European sovereign debt, and likely nursing significant losses. Once Eurozone yields are suppressed then a widening yield differential to Treasuries suggests continued dollar strength.

KBW Bank Index vs EuroStoxx Bank Index shows significant relative strength of US banks. Source: Marketwatch.

The actions of foreign central banks will also be supportive of the Treasury market, but eventually the same problem will appear in the U.S. Global bond markets are tightly interconnected and stability in foreign markets will help stabilize Treasury yields. However, the supply of U.S. Treasuries from fiscal spending and QT is very large even as prior marginal buyers are no longer buying. Eventually, the Fed will also have to step in too.

Treasury issuance is basically $1t+ forever. That suggests higher yields absent Fed intervention. Source: U.S. Treasury

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