The prospect of a burgeoning economic recovery has lit a raging bonfire under government bond yields. The U.S. banking sector could hold the fire extinguisher.
Yes, THAT U.S. banking sector, the one that restabilized financial markets for months. While it may have been a big part of the problem, now it could provide a partial solution to the threat of rising interest rates by delivering demand that could help bring some balance back to the bond market.
Bonds getting tipsy
Michael Gregory, senior economist at BMO Nesbitt Burns, pointed out in a recent research report that there have been some very good reasons for government bond yields' recent surge from unsustainable record-low levels. Massive amounts of government liquidity and stimulus have boosted money supply, triggering inflation worries, which have been compounded by rising confidence in an economic turnaround. These concerns have manifested themselves in the dramatic widening of the yield spread between government bonds and Treasury Inflation-Protected Securities (TIPS) - a key measure of U.S. inflation expectations known as the "break-even spread. "Simply put, higher inflation gets priced into interest rates in order to compensate investors for inflation eating away at their returns.
But another key factor has been the fact that the optimism for an economic and market turnaround has surfaced at the same time as government debt supplies are surging. Just as governments issue more bonds to finance their spending sprees, the demand for them is ebbing, Mr. Gregory said, as investors become less risk-averse and shift away from safe-haven government bonds.
It is to this supply/demand problem that the U.S. banks look poised to ride to the rescue.
Banking on demand
"Coming out of recessions, banks typically increase their holdings of [U.S.] Treasuries and Agencies as a share of assets, a tendency that is even more pronounced following a banking crisis," he noted, pointing to the trend in economic recoveries over the past 40 years. He said banks have traditionally done this to take advantage of steep yield curves at the end of a recession in order to efficiently replenish income they lost during a downturn.
U.S. banks' current level of holdings in these assets are near 40-year lows, at about 10 per cent of their total assets. If they were to rebuild their holdings to 20 per cent - where they were in the recovery following the savings-and-loan crisis of the early 1990s - they would absorb $1.2-trillion (U.S.) in government paper.
"Admittedly, banks still face significant balance sheet constraints," Mr. Gregory said. "However, other non-bank institutional investors with less-constrained balance sheets (e.g. hedge funds) will likely supplement bank demand."
David Parkinson