After inflation, a higher supply of bonds could be the next market shock

Central banks, the most reliable group of bond buyers in developed economies, could cut their purchases of sovereign debt next year by as much as $ 2 trillion in the world’s four major advanced economies, implying a potentially large increase in the borrowing costs of many states.

For years, but especially since the COVID-19 pandemic broke out in March 2020, central banks have effectively supported public spending, absorbing a significant part of the sovereign debt that reaches the markets and preventing yields from rising too high. .

But if central banks set a timetable for withdrawing their pandemic-era stimulus, a shortage of highly-rated bonds available in the market, especially those from Europe, could lead to oversupply.

JP Morgan estimates that demand for central bank bonds in the United States, the United Kingdom, Japan and the euro zone will fall by $ 2 trillion in 2022, following a reduction of $ 1.7 trillion this year.

The broker expects ten-year yields for the United States, Germany and the United Kingdom to rise 75, 45 and 55 basis points respectively by the end of 2022, although it did not specify the impact of the offering on the bonds.

Globally, JP Morgan forecasts that central banks will cause a drop in bond purchases of about US $ 3 trillion, which translates into an average increase in profitability of between 20 and 25 basis points.

“I’m not suggesting that next year is going to be the bond apocalypse, but we have a period where inflation remains stubbornly high, central banks are behind in terms of interest rate hikes, and at the same time time, we have a great net supply, ”said Craig Inches, head of rates and cash at Royal London Asset Management.

“It’s a pretty stormy mix for bond markets,” he said.

The Federal Reserve (Fed) of the United States will end in March the gradual reduction of monthly bond purchases for US $ 120,000 million.

The Bank of England’s (BoE) bond purchase program worth 895 billion pounds (US $ 1.18 trillion) ends this month, while the Pandemic Emergency Purchase Program (PEPP) from the European Central Bank, of 1.85 trillion euros (US $ 2.09 trillion), will expire in March.

Central banks will not disappear from the markets. To compensate for the withdrawal of the PEPP, the ECB will temporarily double its current monthly stimulus to 40 billion euros, while the same bank, the Fed and the BoE will continue to reinvest the proceeds from expired bonds in the markets.

The UK could be the most affected market. ING estimates that private investors will have to absorb 110,000 million net pounds of government securities in 2022, compared to 14,000 million pounds this year, taking into account that the BoE bond purchases in 2021 were almost 170,000 million pounds.

Additionally, the BoE plans to stop reinvesting proceeds from past-due debt once interest rates reach 0.5%, a level that is possible by mid-2022. Once rates reach 1%, it could consider selling the bonds in your portfolio.

The UK government’s gross borrowing plans imply an average of £ 120bn in annual net issuance over the next four years, levels not seen since 2011, according to Craig Inches of Royal London Asset Management.

This scenario is in stark contrast to what happened a year ago, when central bank money printing machines were running at full throttle. In the euro area, yield premiums can rise by 20-30 basis points, according to Ralf Preusser, global head of rate analysis at BofA.

If the markets are correct in betting on the complete end of asset purchases next year, “the impact of rates becomes even greater and runs the risk of being a very significant part of the positive net issuance that we would have to absorb for the first time since the European sovereign (debt) crisis, ”said Preusser.

“The spreads in Europe are not ready for it,” he added.