Excell with Options: Do JPY and GBP have a similar set-up with different outcomes?
Intervention (noun)
: the act of interfering with the outcome or course especially of a condition or process (as to prevent harm or improve functioning)
: the interference of a country in the affairs of another country for the purpose of compelling it to do or forbear doing certain acts
: an occurrence in which a person with a problem (such as a drug addiction) is confronted by a group (as of friends or family members) whose purpose is to compel the person to acknowledge and deal with the problem
- Merriam-Webster dictionary
In the past month or so, we have seen many markets globally continue to struggle. In some places, markets have become so unhinged that authorities have had to step in and arrest the volatility in the market. The two that are most top of mind are the Bank of Japan in the Japanese Yen FX market and the Bank of England in the UK Gilt market.
As we can read from the above definition, the intervention we are seeing in the markets by the BOJ and BOE in the past month would appear to fall under the first definition of intervention. Authorities are attempting to ‘prevent harm or improve functioning.’ However, one might argue that the markets, the bond vigilantes, are also intervening in the markets. Bond vigilante is a term coined by Ed Yardeni in the 1980s to identify bond traders who sell large amounts of bonds to signal a distaste of policies. This might fall under the second definition above, where the market is interfering in the ‘affairs of another country’ for the purpose forbearing certain acts. These acts might be considered the profligate spending and monetization of debt that has possibly occurred across much of the developed world.
In his newsletter “Strategic Bond Investor,” Tony Crescenzi, a portfolio manager at PIMCO, suggests “indebted nations have reached a Keynesian Endpoint:”
“The reawakening of bond market vigilantes suggests that developed nations have reached a Keynesian Endpoint, where practical limits to the use of debt become apparent. The acceleration in inflation may signal attainment of that limit, with the surge probably linked to the extensive use of debt that followed the onset of the pandemic.
More recently, a violent market reaction to a planned fiscal expansion in the UK may signal the existence of a Keynesian Endpoint across the pond, with investors expressing dismay via heavy selling of gilts and pounds. Still more evidence of investor loathing at fiscal follies arrived this month when euro bond prices plunged in reaction to news that Germany may be open to a fresh round of EU bond issuance. “
- Tony Crescenzi, The Strategic Bond Investor newsletter
If we look at a table of the biggest possible offenders, and biggest potential sources of volatility as bond vigilantes fight back, Japan and the UK are at the top of the list, though each is far from being the only offenders on the list. You can see that it is not just the debt to GDP that is outstanding, but it is also the budget deficit as a percent of GDP. Where we see both numbers giving a yellow (if not red) warning sign, we need to take cover.
Post the Great Financial Crisis, Carmen Reinhart and Kenneth Rogoff argued in their book, This Time is Different, that countries would embark on financial repression to force financial institutions into buying sovereign debt, enabling governments to print and spend their way out of an economic hole.
How does this work in practice? I am not going to go into great detail, but in my class I speak to my students about how financial institutions are compelled by regulation to buy sovereign debt:
- Under the Basel III regulation, post the Financial Crisis, banks are required to hold a larger percentage of high-quality liquid assets (HQLA) on balance sheets
- Similarly, under the Solvency II regulation, insurance companies face a similar mandate. This particularly affects European and Asian companies
- Pensions funds this century have been required to do asset-liability matching. With aging populations, this means more bonds must be bought.
Source: Richard Excell class notes
As suggested, real rates went negative in the immediate post GFC world. For all of 2014-2019, real rates were positive but only marginally so. In the aftermath of Covid-19, authorities found it necessary to drive real rates into negative territory again.
Image 1: US 10-year real interest rates embedded in the TIPS market
These negative real rates drove the term premium for bonds persistently lower for the entire post-GFC period culminating with a negative term premium in the entire time post-2018. Time value of money is a foundational principle of finance. It is logical that investors should and have demanded a higher rate of return for locking up money over a longer period of time. However, this repression led to investors actually demanding less interest rate for locking up money longer.