A Looming Bond Market Disruption
While trade tensions and tariff spats have dominated financial headlines in recent months, we have our eyes on potentially bigger risks brewing under the surface - unintended shockwaves in the bond markets. There could be a perfect storm forming that tests the resiliency of government bond markets in the coming months.
US Treasury Risks and Global Spillovers
At the heart of the issue is how the U.S. government will fund itself after July. The U.S. Treasury could run out of cash by late July or early August without a debt ceiling increase. This would necessitate a massive dose of new Treasury issuance, to the tune of $500 billion, in a short period of time. This would be a tough pill for bond markets to swallow. Bonds have had a pretty mediocre, if not bad, year to date, even with minimal net new Treasury supply so far. Trying to digest $500 billion of fresh issuance in the span of a couple months has "potential for disruption."
Making matters more precarious are some unexpected consequences of governments trying to get ahead of this funding challenge. For example, Japan has been issuing debt at an annualised pace of ¥34 trillion, over 3 times its fiscal deficit, to build up a cash war chest. But this surge in bond supply, without an offset from fiscal spending, amounts to a monetary tightening that is weighing on growth. Similar pre-funding efforts by France and the UK could dump even more bonds into fragile markets.
Foreign Demand and Central Bank Intervention
There is also growing unease around foreign investors' willingness to absorb U.S. Treasuries in the midst of trade tensions and deficit concerns. Rumors are swirling about certain countries looking to restructure their U.S. bond holdings. Any hitch in foreign demand would be especially problematic if it coincides with the large slug of new issuance that could hit in the third quarter.
Ultimately, there is a heightened risk of a disruptive bond market sell-off this summer, with yields spiking higher. This could impair funding for mortgages, private equity, and cash-strapped U.S. companies, sapping growth. In this scenario, the Federal Reserve and other central banks may have to revert to some form of quantitative easing or yield curve control to contain the fallout, planting the seeds for inflation down the road.
Why It Matters Now
In other words, the second-order effects of trade skirmishes on interest rates and credit channels could end up being the more destabilising force when the dust settles. Bond market tremors may seem like background noise compared to the blaring headlines on tariffs, but they bear close watching in the months ahead. This probably means we should start positioning for some summer volatility.
Key Points
- Be mindful of the potential U.S. funding shortfall in July
- This comes as foreign demand for Treasuries continues to weaken
- Could prompt potential quantitative easing to manage the fallout
This article has been prepared by InvestSense Pty Ltd ABN31 601 876 528 on behalf of Primestock Securities Ltd. The information contained in this report is obtained from various sources deemed to be reliable. No representation or warranty is made concerning the accuracy of any data contained in this document and should not be relied upon as such.
