Supply Generally Doesn’t Matter for an Individual Government Market

The supply of high-quality global government bonds doesn’t generate much attention because it generally doesn’t matter for an individual market. Because these bonds are the true “core” of the fixed income market, with other types of bonds priced in relation to these developed market high-quality sovereigns, there is almost always enough demand to more than offset additional issuance. As some learned in Finance 101, the markets in these government bonds are the broadest, deepest, and most liquid in the world.

But what will happen when almost all developed market governments need to simultaneously boost sovereign debt issuance? Yields will need to increase across the board to attract buyers to take up the flood of supply. Investors in US Treasuries, for example, will no longer be able to dodge the glut of new issuance in that market that has followed the debt ceiling standoff earlier in 2023 by moving into the gilt market if the UK is also selling an increasing volume of new debt to fund its spending.

Ballooning Fiscal Deficits

Action to Shift to Long End of Yield Curves

As a result of these supply dynamics, much of the action could move to the long end of yield curves, while in 2022 shorter‑term yields were more volatile as curves sharply inverted. The two‑year US Treasury yield increased 370 basis points (bp) last year, while the 30-year Treasury yield “only” climbed 207 bp. German government yields followed a similar course, with the two-year yield rising about 335 bp (from deeply negative territory at the end of 2021) and the 30-year bund yield increasing only 62 bp.⁴

This should result in a “twist” in yield curves, with long-end rates most likely increasing and curves steepening. In 2011, the Federal Reserve purposely targeted lower long-term yields in “Operation Twist” by selling short-maturity Treasuries and buying longer-end securities. Today, however, I think that we may be entering a period where central bank actions don’t have much effect on long-term rates because of the distortions caused by the flood of supply.

Ominous Potential to Crowd Out Corporates

Most ominously for the economy, a huge boost in high-quality government bond issuance could also crowd out many other borrowers, or at least force up funding rates for corporate borrowers and others that need to refinance. This would raise the cost of funds for corporations and make them less likely to spend on capital projects or hiring more employees, removing a vital source of support for the global economy just when it needs it most. Also, remember that long-end yields act as the discount rate for many other purposes, so this twist could have far-reaching impacts.