The world of abundant savings was not derailed by the Great Recession and the financial crisis, despite the ballooning of sovereign budget deficits. In fact, the crisis has reinforced the reflex to save. Austerity is being forced on much of Europe and U.S. fiscal policy has tightened by two percentage points this year. In addition, U.S. consumers are still deleveraging and the corporate sector has borrowed largely to refinance and return cash to shareholders rather than invest in capacity expansion.

 

This implies that the world will continue to be awash in yield-hungry cash over the coming years. Simultaneously, high-quality bonds could be relatively scarce as a projected smaller U.S. deficit means that the Treasury will need to sell less debt. In addition to ongoing demand from sovereign reserve managers such as China, and fresh demand from Japanese investors seeking safe yields higher than Japanese Government Bonds (JGBs), regulatory changes will boost global bank demand for highly-rated bonds by trillions of dollars. Central bank absorption of sovereign and other bonds will only add to the potential dearth of high-quality fixed-income assets, squeezing private sector fixed-income demand.

 

The search for income, however, does not mean that government bond yields will be at depressed levels forever. The benchmark yield curve is influenced by global supply and demand for high-quality instruments, but shifts in the curve will continue to be driven by changes in U.S. growth and the associated changes in the Fed funds rate. The Fed is signaling that it has mapped out a strategy to wind down its bond-buying program in thoughtful steps. Thus, the bond bear market may begin late this year, although the timing will depend importantly on the employment picture and when the Fed actually tapers its quantitative easing (QE) program. As mentioned above, the global demand for high quality bonds may offset any reduction in the Fed’s QE purchases. Even when growth picks up and the Treasury bear market begins, spreads should be flat-to-tighter until corporate releveraging is at an advanced stage and the Fed has lifted short-term rates close to neutral.

 

European policy makers are considering new ways to revive their ailing economy as they confront fresh pressure to take action. The bloc’s finance ministers and central bankers are open to scale back austerity, increase monetary aid and unfreeze bank lending as well as review aid payments for crisis-struck nations from Greece to Spain. Several factors are making it easier for Europe’s policymakers to backtrack on obsessive austerity. For example, the link between austerity and poor economic performance is very clear. Also, financial markets support some austerity slippage: the election of anti-austerity forces in Italy, budget deficit slippage in Spain, and the Portuguese Constitutional court’s decision to strike down some austerity measures has had no adverse effect on the ongoing bond market rally. The European Central Bank (ECB) is also debating what more it can do, and is considering buying asset-backed securities to support lending to small and medium-sized businesses. ‘Abenomics’ offers a template for Europe. Japanese Prime Minister Abe pledged a fiscal stimulus equal to 2.3% of GDP to be launched in 2013, which did nothing to dent the rally in Japanese Government Bonds (JGBs). Abe has illustrated the importance of accumulating political capital through monetary and fiscal stimulus measures, in order to pursue structural reform later in his term. The idea is to establish credibility by generating nominal growth, and then to push through unpopular and painful reforms.

 

In May, expect heady markets, Benghazi, and other scandals to capture headlines. Lower Federal deficits mean that the debt ceiling will not become a binding constraint on the Treasury until late September. This sets the stage for simultaneous negotiations on a Grand Bargain, the 2014 Budget (with threat of government shutdown), and the debt ceiling.

 

 

Michael Ashley Schulman, CFA

Managing Director