The outlook for bonds after the pandemic

  • To understand the issues facing bond markets right now
  • To learn about the impact of higher interest rates on bond markets
  • To learn about conditions in the high-yield bond market

Money supply growth remains high

Against this backdrop, central banks have continued to keep monetary policy loose, buying bonds and other financial assets and holding interest rates at historically low levels. These actions reflect the concern when the pandemic began that it would be viciously deflationary. Policymakers had to act fast to support the financial system by ensuring adequate levels of liquidity. In this regard, they have been effective. 

On a global basis, central bank liquidity has been the main driver for risk assets in the wake of the pandemic, with $17tn (£12.8tn) of credit created in 18 months.

While money supply growth has since fallen from its early 2021 peak, it remains historically high, even compared to the financial crisis. 

This is likely to continue to pass through to prices. A big difference between today and the period after 2008 is that, back then, while central banks used quantitative easing to try to grow the money supply, liquidity was being continuously drained as banks parked capital back at the US Federal Reserve to rebuild buffers and meet more stringent reserve requirements. Today, bank balance sheets are relatively healthy, so Fed stimulus has added substantially to the stock of money.

This means there is more of the extra liquidity in the system available for commercial banks to place in the real economy now, as much of the liquidity created in response to the global financial crisis had to be used by banks to meet regulatory requirements, but exiting the pandemic-induced recession, banks balance sheets generally retain more than the minimum required amount of capital, so have no need to retain any of the newly created cash. 

Couple this with supply bottlenecks and the reining back of globalisation and conditions are ripe for inflation being less transitory than some have hoped.

Do not fear the taper

Rising inflation puts pressure on central banks to tighten policy. The Fed has hinted at plans for a quick taper of asset purchases by mid-2022 and indications are that rate hikes could begin in 2023, earlier than previously signalled. Alongside the Fed’s taper commitment, the US Treasury is expected to rebuild the reserves it holds in the Treasury General Account, which it has been running down since early 2021.

This withdrawal of stimulus could create short-term volatility in bond markets, including rising treasury yields and widening credit spreads. Nonetheless, conditions are unlikely to tighten as sharply in 2022 as many fear.

While the Fed expects to taper at a pace of $15bn a month, the winding down of pandemic support means the supply of treasuries should also slow as the US budget deficit narrows. Certainly the market is taking it in its stride so far, with 10-year treasury yields currently only around 1.5 per cent even with rising inflation and the imminent prospect of tapering.