ref: - "Tail Risk" by Tommy Stubbington, The Financial Times, Companies and Markets 13/11/19
Apologies for pointing you to a piece that appeared yesterday… we weren't able to get to it then but it's worth a look as it not only ties in pretty neatly with what we were talking about on Monday but also addresses what is perceived as the most basic truism of any market-place. That is to say that ultimately, the interaction between supply and demand determines the price.
On Monday we were ruminating about the sharp pick-up in stocks and bond yields (and drop in bond prices), and how such moves had dragged the yield curve back into positive territory. That's a much more welcome picture for the economic future, but you don't have to be the worst pessimist in the world to wonder if some people were taking a lot for granted. In particular, to assume that some friendlier noises surrounding the very first, small step towards PHASE ONE of a US-China trade agreement automatically points to a much broader rapprochement is a huge leap… especially when the most important player in the piece, the US President, is prone to changing position in a trice.
As if on cue, Donald Trump turned all Mr. Nasty again and since any prolongation of the trade dispute is seen as bad news for the global and US economy, stocks and bond yields immediately backed off … by 10 basis points in the case of the 10yr US Treasury. It all goes to tell us something we already knew: that these are volatile times and that a concerted move into more risk-on investments and out of risk-off havens (such as US Treasury bonds) may be a tad premature.
Anyway, the price /supply/demand thing…
Many traders will remember times when, thinking they must have missed some important breaking news, they asked colleagues why the price of something was suddenly shooting higher (for example). "More buyers than sellers!" was the answer often yelled back. At some point in the dim-and-distant, someone must have thought that such a reply was vaguely humorous. It was never very funny and always entirely unhelpful, only illustrating the fact that everyone in the room was as much in the dark as everyone else. Irritating though it was, however, it was undeniably true even if the reasons behind the buying enthusiasm may have been unclear.
The idea that demand outstripping supply forces prices higher, and the opposite sends prices lower, is hardly an obscure concept. It's a relationship most obviously seen when trading commodities and needs little explanation. If the demand for wheat (say) remains constant but the crop yields (the supply) are higher than expected, the price falls. Nothing could be simpler.
Things maybe a little more complicated when it comes to financial instruments. For one thing, data is less easy to interpret, but when all's said and done, surely the principle remains the same? After all, wasn't the huge demand created by central bank buying of a finite amount of bonds (Quantitative Easing) a huge factor in sending bond prices through the roof and bond yields through the floor?
You'd definitely think so, wouldn't you? QE has definitely played a massive role in the latest leg of the 30-year bond rally that at one stage saw $17 trillion of global bonds trading with a negative yield. More than that, alongside the hopes for a resolution of the trade conflict much of the recent upside turnaround in bond yields (and therefore falls in prices) has been put down to expectations of an increase in supply. In bond markets, supply means the issuance of debt, and with an ever-increasing number of policymakers taking the view that the effectiveness of monetary policy is about exhausted, the assumption is that further major stimulus will have to be fiscal in nature. That means more government spending, which of course will entail more government borrowing… and that means issuing more bonds. Bigger supply means lower prices (and higher yields).
But Mr. Stubbington tells us that the truth is that historically speaking the simple supply/demand equation does not necessarily apply with bond markets. In fact, and surprisingly perhaps, the correlation between levels of bond issuance and yields is weak. Bond yields are ultimately determined by expectations for the path of interest rates. Large amounts of fiscal stimulus will only be instrumental in boosting yields over the long term if such a policy is successful in boosting growth and therefore pushes central banks to raise rates.
So, in the case of bond markets extra supply does not necessarily mean lower prices… however logical it feels.