An ‘Epic Supply-Demand Battle’ Is Looming Across Bond Markets

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In coronavirus-rocked debt markets, a historic wave of government bond selling is meeting the biggest monetary buying program on record.

But even as central banks unleash their trillions, the issuance spree across developed economies is proving far from smooth sailing.

Bill auctions are struggling in Spain and France. Hedge funds are seeking ways to exploit supply-and-demand glitches in Australia. In the U.S., the Federal Reserve’s slower-than-expected pace of debt buying this week is catching some traders off-guard.

Few would doubt the resolve of monetary policy makers to help administer a fiscal cure for pandemic-hit countries. But that still leaves plenty of room for trading hiccups in key market corners as huge gross volumes test nerves.

“What we are seeing now is a kind of an epic supply-demand battle going on in the government bond market,” said Gopi Karunakaran, a money manager at Ardea Investment Management in Australia. “What that is doing is creating anomalies depending on where central banks decide to buy and where they are not buying.”

Ardea, an A$13 billion ($8.3 billion) firm founded by a group of former Wall Street prop traders, is betting that interest-rate volatility returns to their home market by snapping up long-dated bearish options.

Traders in the world’s largest bond market have stayed on high alert on monetary buying plans, belying the Fed’s open-ended program. Longer-dated Treasuries sold off Friday when the central bank announced it will halve the pace of buying to $15 billion a day this week.

As U.S borrowing moves from Treasury bills to longer-dated securities, some volatility can be expected, according to Priya Misra, global head of rates strategy at TD Securities.

“I think central banks will end up offsetting the supply shock, but it won’t be a straight line,” she said. “We don’t know how long the Fed will buy for or how much per week. So the market gets nervous — and we know that a lot of supply is coming down the pike.”

Monetary officials around the world are deploying trillions to rescue the locked-down global economy from plunging into a depression. The Fed’s balance sheet has ballooned by almost 50% since the end of February to a record $6 trillion, and there may be trillions more in stimulus spending from the U.S., Europe and Asia.

The U.S. central bank is expected to buy a total of $3 trillion in Treasuries by the end of 2021, including $2.4 trillion by the end of 2020, according to TD, mostly offsetting the trillions of additional supply projected over that period.

Even with its daily outlay to buy Treasuries, “long rates are not moving down,” said Torsten Slok, chief economist at Deutsche Bank AG. To him, that’s a sign of waning real-money demand.

In Europe, ECB buying is expected to actually shrink the amount of bonds available to private investors by 210 billion euros ($228 billion) through 2021, according to TD — even after 1 trillion euros of extra borrowing. That should be paving the way for an easy borrowing spree, yet recent auctions failed to inspire the usual investor interest last week.

In Spain, even a positive yield on 12-month bills saw the lowest level of participation in over a decade. France fared little better, with the lowest oversubscription rate on a sale of six-month bills in three years, despite offering a yield above the ECB’s -0.5% deposit rate.

Subhrajit Banerjee, a fixed-income strategist at HSBC Holdings Plc, sees lingering funding pressures as euro-area sovereigns ramp up bill issuance.

“Markets are under-pricing an extended period of euro funding uncertainty with the ECB’s tools potentially ineffective,” he wrote in a note published Monday. “Short-term euro rates will remain volatile in the medium term.”

Read more: Deluge of Bills to Fund Virus Response Adds to Saturated Market

The broader takeaway? The challenge may lie with how governments and central banks are putting their borrowing and buying plans into action rather than overall demand. In Australia for example purchases have focused on shorter-dated debt as the central bank seeks to underpin three-year yields near 0.25%.

The government’s sale of A$13 billion $13B in Syndicated Bond” class=”terminal-news-story” target=”_blank”>notes of notes last week were priced cheaply relative to existing debt, but will eventually converge to outstanding benchmarks and more importantly, roll down to where the central bank is most active through yield-curve control, according to Karunakaran. And that’s creating all manner of trading opportunities.

“It’s a good example of the relative-value curve anomalies created by the demand-supply tension of governments — needing to sell lots of bonds to finance fiscal stimulus — versus central banks implementing their QE programs in different ways across different markets,” he said.

— With assistance by Anchalee Worrachate, Garfield Clinton Reynolds, and John Ainger

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