LONDON: A standoff between central banks and their cash-strapped governments may well be looming as an intensifying bond market crunch reopens questions about the political independence of the banks well beyond their interest-rate policy.
Central banks currently appear reluctant to rebuild holdings of sovereign debt, yet those holdings played a significant role in the swelling public borrowing over the past decade. Moving forward, that means either an improbable fiscal tightening will need to emerge or political knives will be sharpened.
Numerous elections in the US, France, Italy and Spain over the coming year mean significant spending cuts are unlikely to be on the agenda. If bond markets continue to tighten — as we've seen in recent weeks — political pressure on central banks to steady the ship will rise even further.
Seeing the problem coming like a slow-motion car crash, central banks are trying to nuance their position.
On one hand, a post-pandemic consensus has built around further "normalisation" of their bond-packed balance sheets. This includes a retrospective disdain for using bond accumulation as a monetary policy tool. On the other hand, policymakers want to keep all options open for temporary fixes in the event of market malfunctioning or another left-field shock.
Bank for International Settlements (BIS) boss Pablo Hernandez de Cos this week laid out some principles for using emergency tools if conditions get rough, using the example of the Bank of England's (BoE) limited and brief support for stressed British gilts during the budget blow-up in 2022.
"A key challenge is to bolster market confidence without overstimulating the economy in the longer term," he said of such emergency tools. "Central banks should try to better distinguish programmes for market functioning from those for monetary stimulus."
But the problem with a middle-ground, only-in-emergencies approach is that sometimes debt markets can get squeezed even when there isn't an acute crisis.
Just look at the current global bond selloff. Markets are not necessarily malfunctioning, and despite the clear energy hit from the Iran war, there's no global shock on the scale of Covid-19 or the 2008 banking crash to justify a red alert. Yet markets continue to inflict maximum pain on government debt-service bills.
Should this continue, alongside a relatively hot AI-infused economy and above-target inflation rates, monetary policymakers could find themselves in a very tough spot. If central banks do step in, the lines between "backstops," monetary policy and direct government support could become blurred, and central bankers could once again find themselves criticised for enabling rising government debt loads.
Yet governments across the developed world may expect them to do just that if sovereign bond yields keep increasing. Rising debt-service bills are coming at a time when ageing demographics in most Group of Seven (G7) economies have already been heaping pressure on pension and healthcare systems, while defence spending is set to spiral higher amid increasingly fraught geopolitics.
Pointing to forecasts that global government debt will exceed annual global GDP by 2030, International Monetary Fund head Kristalina Georgieva this week warned rich governments to deliver credible fiscal-consolidation plans urgently and not fall back on central banks to bail them out.
"I would call these 'monetary cowboys', running to the rescue of the fiscal agents, and my message is: please don't."
HOW DID WE GET HERE?
For context, we need to rewind a bit.
Of the multiple reasons cited for the intense government bond market selloff in recent months, a big question revolves around the gaping hole left in debt markets by the gradual withdrawal of G7 central banks from the swelling debt piles they facilitated following 2008. The selloff has pushed long-term US sovereign borrowing costs to their highest in almost a quarter of a century.
Perhaps the best way to understand how artificially cheap borrowing distorted the picture is to examine how quickly governments accumulated debt when their central banks were buying bonds and effectively underwriting large chunks of it.
The Washington-based Institute of International Finance recently estimated that even though average government borrowing costs across the G7 are back at mid-2008 levels, annual interest expenses are 85 per cent higher because G7 government debts have almost trebled to more than US$60 trillion in the interim.
Advanced economies collectively are now paying over US$3.3 trillion to service bonds alone, it said, which is more than their estimated spending on either AI, defence or clean energy.
But coinciding with, and aggravating, the recent surge in government debt costs has been the steady pruning of central bank balance sheets over the past four years. The aggregate G7 central bank balance sheet peaked at over US$30 trillion in bonds in early 2022 and has been cut by about a third since then. Along with the sharp rise in central bank policy rates to choke off inflation, that one-third reduction has coincided with a 40 per cent drop in long-term G7 government bond indexes and a four-percentage-point spike in their implied borrowing rate.
Have central banks exited too much or too quickly, and should they pause that withdrawal until they rethink it?
BALANCE SHEET PHILOSOPHY
Opinion on the wisdom of so-called quantitative easing (QE)—massive central-bank bond-buying programmes—has done an almost 180-degree turn since the inflation spikes and debt explosions of the pandemic and its aftermath.
For many, the banking crash of 2008 and 2020's Covid-19 lockdowns justified extraordinary one-off balance sheet reactions from the Federal Reserve and others. But many also now criticise the continuous use of bond buying as an ongoing monetary tool, arguing that it underwrote the massive expansion of government debt over the past 20 years.
Much of the central bank world now feels the experiment may have been misguided at best, both because it tiptoed into quasi-fiscal territory and because of a variety of market distortions and inequality questions that arose from what was essentially direct support for wealthier asset owners.
New Fed Chair and long-time balance-sheet-expansion sceptic Kevin Warsh claims the whole 18-year QE episode "borders on fiscal policy". He has already set up one of his Fed reform task forces to look at ways to reduce the balance sheet holdings further.
On the other side of the pond, the BoE is still actively selling gilts, albeit with recent plans to concentrate sales in short-dated paper. And the European Central Bank is still actively running down its balance sheet, which amounts to more than 40 per cent of the Eurozone GDP, even as the region faces echoes of the 2011-12 euro debt crisis in French bond markets. A change of ECB leadership is also on the horizon, and the leading candidates don't appear to have an appetite for a return to the 2010s and the firefighting activism of former chief Mario Draghi.
TWITCHIER TREASURIES
There is also the question of who is holding government debt.
The reduction of G7 central bank bond holdings has coincided with reduced pension-fund demand for long-dated government debt as defined-benefit schemes dwindle and pension savers retire.
Those gaps left by long-term investors keen on safety and steady coupons have increasingly been filled by more speculative, short-term players such as hedge funds, who are much more sensitive to big price shifts, vulnerable to short-term interest rate changes and prone to herding in volatile conditions.
Hedge fund activity in sovereign bond markets has been the focus of regulators for years. While everyone welcomes the demand and liquidity they provide, there is now growing concern about the flipside of that if this "fast money" base gets twitchy.
Some efforts have been made to reduce excessive leverage in government bond markets, but no matter how that pans out, the scale of hedge fund activity in these markets, and by extension the exposure of the banks and trading houses that provide them with leverage, makes for a more skittish environment.
"These buyers are more inclined to sell bonds in response to higher short-term interest rates — funding leg sensitivity — and charge a higher price for the risk of further upward moves," wrote Carlyle strategist Jason Thomas. "When coupled with the growth in the outstanding volume of debt, this new class of investors has left bond markets more fragile and sensitised to front-end repricing."
This sensitivity helps to explain the recent disturbance in Treasury markets, which seems to have been driven largely by the Fed changing course on short-term rates.
SMBC Nikko's rates strategist Joseph Abate cites Fed studies trying to quantify that sensitivity. Fed economist Phillip Monin estimates that hedge fund demand for cash-futures arbitrage plays has increased fourfold since 2020 and is now 3.5 per cent of outstanding Treasury supply.
Another Fed study last month by Daniel Beltran and Canlin Li found that the market's sensitivity to new supply had doubled over the past decade, with every 1.0 per cent increase in new debt, some $300 billion or more, increasing 5-year yields by 8.0 basis points.
Regulators, governments and central banks are watching this closely. But any planned tightening of rules could well have adverse effects at a politically risky moment. While the answer, in theory, may be reducing the supply of government debt, in practice, that is very unlikely to occur.
The alternative solution lands back in the lap of now more hesitant central banks — kicking and screaming perhaps.
© New Straits Times Press (M) Bhd