011918 us fixed income supply growth

An influx of new fixed income supply over the coming 4+ years is going to have a difficult time finding enough increased marginal demand to fill the void left by central banks gradually winding down their balance sheets.

Assist FX sees this heightened supply trajectory as a troubling drag on bond prices, thus pressuring interest rates higher across the curve. Higher bond yields will at one point provide enough attraction for capital to flow back into high quality fixed income rather than equities, all else equal. But at what point will that really occur if buyers of fixed income products feel like they are being chased by more and more supply coming in behind them? They know the new supply could harm the value of their current bond holdings if there is insufficient bond demand.

The logic goes something like this: if a large asset manager can gain a “safe” 3% yield on government debt securities, why should they gamble on a heavy equity weighting at historically stretched valuations?

While this logic is historically valid, it does contain one problem as we move forward in time rather than back–more excessive debt levels. We’ve extensively covered the topic of the downside residual risks posed by excess debt buildup during the QE era. One of these risks might be a higher neutral interest rate than currently expected by the market.

It is highly doubtful whether risk assets can sustain notably higher interest rates and true monetary policy normalization if central banks meaningfully reduce their level of accommodation just as fixed income supply surges higher.

We see this leading to our “moment of truth” thesis scenario where central banks are either forced to abruptly let the air out of their own artificially inflated asset prices in a way which could spark a wave of sharp price declines in risk assets, or keep nudging the goal posts higher on the amount of inflation they will tolerate in an attempt to avoid a hard landing.

We continue to believe there is a market underappreciation of the latter scenario. How it plays out will decidedly influence real interest rates, asset prices, and FX.