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The fixed income market is one of the main pillars for managing an investment portfolio and understanding the functioning of global markets and macroeconomics. Bank credit and debt capital markets are the lifeblood of the financial system.
If you are new to Bond Markets / Fixed Income click here for an introduction to bonds.
MacroVar logic for Fixed Income
Government Bonds explained
The bond market determines interest rates based on the demand and supply of bonds traded. An interest rate is the price paid for borrowing funds. The level of interest rates is critical for a country’s economic activity since it affects consumers and businesses decisions.
The government bond market supply is determined by the country’s issuing of government bonds (also known as sovereign debt) to raise money to finance their government budget deficits. Government budget deficit is the gap between the government’s spending and its revenues. When deficits are large, the Treasury sells more bonds, causing the quantity of bonds supplied in the market to increase and government bond prices to fall given the same level of demand for bonds.
The government bond market demand is determined by two types of buyers: the country’s central bank and private investors.
Central Banks & Government
Central banks and the government determine the country’s monetary policy and fiscal policy. There aim is to keep the country’s economy healthy with stable inflation, solid economic growth, and low unemployment. When the country’s economy weakens, the country’s policy makers react to bring back economic growth as follows:
- Fiscal policy: the government spends more than it receives and finances it’s fiscal deficit by issuing government bonds/
- Monetary policy: the central bank expands it’s balance sheet (prints money) and uses the proceeds to purchase government bonds in order to cause interest rates to fall and a boost in economic activity. Economic stimulation is accomplished in the following ways: 1. wealth effect which is people spending more as the value of their financial and real assets rises, 2. Rising demand of interest rate sensitive goods (real estate, durable goods like cars), 3. Easing of debt service (monthly interest payments are lower).
The country’s central bank and government actions must be very prudent since rising government deficits and monetization of debt by printing money may lead to disastrous economic problems like loss of confidence in the country’s currency and hyperinflation.
Investors
Investors trade government bonds based on their expectations of future economic growth and inflation.
The most important criteria to categorize government bonds are:
- Government Bond maturity (Short-term bonds: 1 to 4-year maturity, Long-Term bonds: 10-year to 30-year maturity)
- Government Bond Credit risk based on the country’s credit profile
Government Bonds and Credit Risk
The government bonds considered the low-risk investments and used for capital protection during recessions and downturns are the US 10-year Treasury note bond and the German 10-year bond.
The government bonds which considered high risk are the bonds of emerging market countries like Turkey and Hungary, and countries of southern Europe namely Spain, Italy, Portugal, and Greece.
Government Bonds and the factors affecting them
MacroVar monitors government bonds of 2-year, 5-year and 10-year maturities for the 25 biggest economies in the world.
Short-term government bonds (the 2-year government bond is the benchmark for short-term bonds) is driven by the market’s expectation of the central bank future moves. The long-term government bonds (the 10-year government bond is used as the benchmark of long-term bonds) is driven by the market’s expectations of inflation and economic growth.
Factors affecting Government Bonds
Inflation ExpectationsInflation is the most critical factor affecting government bonds. A government bond’s coupon rate is fixed for the bond’s life. Hence during inflationary conditions, the price of government bonds tends to drop, because the bond may not be paying enough interest to stay ahead of inflation.
Long-term government bonds offer higher interest rates than short-term government bonds to account for the increased probability of inflation rising at some point during the bond’s life.
Financial health of a Country
The financial health of the country issuing the government bonds affects the coupon rate the bond is issued with. Countries with low credit risk issue bonds with lower interest rates, while those countries with higher credit risk like some emerging market countries will have to offer higher rates to incentivize investors.
Government Bonds and the Economy
Real economic growth expectations and the inflation outlook of the global economy drive all financial assets. There are 4 economic environments based on economic growth and inflationary conditions.
- Inflation boom Accelerating Economic growth with Rising inflation
- Stagflation Slowing Economic Growth with Rising Inflation
- Disinflation boom Accelerating Economic growth with Slowing Inflation
- Deflation Bust Slowing Economic Growth with Falling Inflation
Long-term government bonds are the best financial assets during periods of environments of deflation and disinflation. Government bonds are the worst financial assets during periods of inflationary booms with rising inflation and stagflation.
Government Bonds and Market Risk
During global economic expansions when inflation expectations are positive, capital flows out of low-risk assets such as US treasuries and German bunds into higher risk financial assets such as stocks. Inside the bond market, during healthy economic conditions capital flows from safe German bunds to riskier bonds of the Eurozone periphery like Italian government bonds and Spanish government bonds and from low-risk US treasuries to other emerging market bonds in search of additional yield.
During economic slowdowns where the market expectation is disinflation funds flow from risky assets like emerging market bonds and stocks to low-risk financial assets like US treasuries and German bunds.
Government long-term bonds perform well during a weak economic environment with low inflation expectations and no economic growth expectations. Moreover, a global bond rally may indicate a rotation from risky assets like stocks to low risk assets like bonds.
Low economic growth can arise from a global slowdown affecting a specific economy, low commodity prices affecting commodity export oriented economies like Canada / Russia, geopolitical events affecting adversely economies like Brexit, a domestic economic slowdown, falling exports for export oriented economies like that of Germany, QE intervention or market front running of QE intervention.
Fiscal interventions like government infrastructure spending projects adversely affect government bonds (both short-term government bonds and long-term government bonds) since they sense increased projected inflation expectations.
Emerging countries are often vulnerable to capital outflows for various reasons. Capital outflows cause heavy losses in emerging countries government bonds. If you want to learn about emerging countries risks and opportunities click our guide on emerging economies.
Factors affecting Government Bonds
Government bonds are highly correlated with the factors presented below. However, during extreme economic downturns, central banks use extraordinary measures to combat recessions like extensive quantitative easing programs (money printing) with which they purchase government bonds of all maturities hence distorting price discovery.
The factors affecting government bonds are summarized with the case studies below:
- Low-Risk Government bonds like the US and Germany 10-year bonds rally on global slowdown conditions.
- Government bonds are closely correlated with the country’s economy expectations. When leading economic indicators show economic slowdown government bonds rise. Leading indicators used to gauge the country’s economic expectations are the following:
- All economies: Manufacturing PMI, Housing activity, Domestic Banks exposure
- Commodity dependent economies: Commodity trends and momentum
- Export oriented economies: e.g. Germany exports to China, Australian exports to China
- Geopolitical Events: Brexit, Political Crisis (Italy), Trade wars, Tariffs
- Central Bank Expected Interventions: e.g. Front-running ECB Quantitative Easing programs for Italian Bonds
- Emerging market Bonds: During rising global risk conditions, capital moves out of emerging market bonds into low-risk assets like US 10-year treasuries and German Bunds
- Government infrastructure programs: New debt issuance to finance new projects lead to a fall in both short-term and long-term bonds.
MacroVar financial models monitor government bonds for the largest 30 economies in the world based on the following factors:
- Manufacturing PMI Momentum (Y/Y) vs 10Y government bond rate Momentum (Y/Y)
- Economic Sentiment Indicator (Y/Y) vs 10Y government bond rate momentum (Y/Y)
- Consumer Price Index levels vs 10Y government bond rate levels
- Economic Sentiment Retail Prices levels vs Country 10-year government bond rates levels
- Exchange Rate levels vs 10-year government bond rates levels
- Stock Market Index momentum (Y/Y) vs 10-year government bond rates momentum (Y/Y)
Other factors specifically used for the US 10-year government bond are:
- Global Manufacturing PMI Momentum (Y/Y) vs US 10-year treasury bond
- US ISM Manufacturing PMI Momentum (Y/Y) vs US 10-year treasury bond
- US ISM prices Momentum (Y/Y) vs US 10-year treasury bond
- US 5-year forward inflation expectation rate vs US 10-year treasury bond
Since CPI is a coincident indicator, MacroVar uses US ISM Manufacturing prices and ESI retail prices for all European countries as leading indicators to predict government bond trends early.
Click on a government bond’s link to explore up to date analysis of the factors affecting it. Moreover, government bonds are closely correlated with sovereign credit default swaps. The credit default swaps market reacts faster than the bond market it is advisable to monitor it closely.
To gain a closer view of government bonds you, check our yield curve monitor.
Risk On: EM Bonds, Club Med vs DE, Risk Off: US / DE (vs Club Med)
Global disinflation (inflation down) = Global low growth expectations = Global CB dovish = Global rates down = 10Y Bonds soar
Bond rally Causes: Global slowdown, CA: US, Oil, Housing, GB: PMI down, hard Brexit, AU: China, Housing, DE: Export, Brexit, IT: front running for ECB QE, ES: PMI plunge, Domestic Banks, EM Bonds: Risk On, Safe haven – US treasuries, Bunds (vs BTPs), HYG: Risk On
Bond selloff: When markets think economic boost like in trade deal hope. Government infrastructure spending (more new debt) fall in both short- and long-term bonds
Introduction to Bonds and Fixed Income Markets
What is a bond
A bond is a debt security that promises to make interest payments (also called coupon payment) periodically for a specific period and pay back the initial capital borrowed (also called maturity value, face value) when the bond matures.
Government Bond Prices and yields
Government bonds are issued and backed by national governments. Government bonds are considered low-risk investments, but they often entail hidden risks and benefits. MacroVar analyzes government bonds of the 25 largest economies in the world. Government bonds are dependent and intricately linked with the rest of world markets, the global economy, individual country economies, central banks, and governments actions.
Government bond prices are intricately linked to current interest rates. Higher interest rates lead to lower government bond prices. The reason is that if current interest rates are higher than the level of interest rates when the existing government bonds were issued, the prices of those government bonds will fall because new government bonds will be issued with higher coupon rates making the old outstanding government bonds with lower coupon rates, less attractive unless they can be purchased at a lower price. Conversely, lower interest rates mean higher government bond prices.
Government Bonds Example
We buy a government bond with a coupon rate of 2%, price of the bond is $1,000 and the government bond matures in 10 years. The bond price fluctuation is determined by the maturity date of the bond and yields.
One year later, interest rates fall to 1.5%. Buyers can only get 1.5% on new bonds issued so they are willing to pay more for our bond yielding 2% which pays higher interest. In this case, the price rises to $1,080. At a price of $1.080, the yield to maturity of this bond now matches the prevailing interest rate of 1.5%.
Three years later, interest rates rise to 3%. Buyers now get 3% on new bonds issued so they are willing to buy our bond yielding 2% paying lower interest at a discount. The price falls to $900. At a price of $900, the yield to maturity of this bond now matches the prevailing interest of 3%.
Money markets
Money markets allow the flow of short-term capital between lenders and borrowers. Money market instruments are the safest assets in the fixed income arena since they are short-term however during periods of high financial risk like 2008 credit risk exists.
The money market includes short-term credit market instruments.
Treasury securities
Countries raise capital using long and short-term debt. The treasury raises funds in the money market by selling US Treasury bills typically expiring from 1 to 12 months.
Commercial paper
Commercial paper is an unsecured, short-term debt obligation of corporations and banks. They usually have a maturity of 90 to 270 days. Commercial paper is used for short-term financing needs. The advantage of commercial paper relative to short-term borrowing from banks is the lower rates paid.
Treasury Inflation-protected securities (TIPS)
TIPS is a form of US government debt linked to US inflation index. As a result, investors don’t suffer from the negative effects of inflation. They are issued on a quarterly basis with 5-year, 10-year and 30-year maturities.
Breakevens
Breakeven inflation rate is an instrument giving exposure to the inflation rate based on the implied inflation from TIPS.
Nominal Rates (based on US Treasuries) – Inflation (Breakevens) = Real Rates
Time deposits
Time deposits also referred to as certificate of deposits or CDs, are bank deposits which cannot be withdrawn without a penalty for a specified maturity date. Typically the maturity of time deposits ranges from 30 days to 5 years.
Interbank Loans
Interbank loans refers to a market where banks loan capital to each other. Most interbank loans are done overnight for maturity of 1 week or less.
Repurchase agreements
Banks raise funds through repurchase agreement or “repos”. A repo is a sale of securities with an agreement by the seller to repurchase them at a later date.
LIBOR (London Interbank Offered Rate)
LIBOR is the most important rate in global financial markets. It is the rate at which banks borrow from each other. The 3-month LIBOR is the dominant gauge. During periods of financial stress, LIBOR rises due to the high counterparty risk between banks.
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Eurodollar Futures
Eurodollar deposits are time deposits at banks in US dollars outside of the Fed’s jurisdiction. A Eurodollar futures contract is a contract on 3-month LIBOR spanning 3 months from the initial date.
Interest Rate Swaps
Interest rate swaps are derivatives allowing an investor to exchange one set of interest payments for another. the most common interest rate swaps are fixed-for-floating where investor or hedger receives a fixed rate to pay for a floating rate and vice-versa. If someone is a receiver of rates, he believes the floating portion will drop and vice-versa.
Federal Funds
Fed funds are unsecured loans of reserve balances banks and other institutions make to one another. The rate at which these transactions occur are called Fed Fund rates set by the Federal Reserve. The most common duration or term for fed funds is overnight.
The FOMC sets a target level for the fed funds rate, the most important tool for monetary policy. However, the availability of banks between institutions determines the final rate. Any reserves of banks kept at the Fed in excess of reserve requirement are considered excess reserves.
The Fed during financial crisis, provides excessive funds to banks causing them to hold reserves in excess of the requirement. The fed pays interest on excess reserves (IOER). Since there is a large amount of excessive reserves, the effective Fed funds rate and IOER are below the Fed funds target rate.
Investors can trade Fed funds using the Fed Funds futures contract trading in the CME.
Overnight Indexed Swaps (OIS)
Overnight index swap (OIS) is fixed-for-floating interest swap indexed against the overnight rate, in the case of US the Fed effective rate. They have a maturity of less than two years and are used to speculate in central bank action.
LIBOR-OIS spread
LIBOR-OIS is one the indicators MacroVar uses to gauge financial stress. LIBOR is an unsecured lending rate among banks, while OIS is based on Fed effective rate. This spread widens during periods of elevated financial risk when counterparty risk between banks is rising.
