2021年10月25日

The end of the 40-year bull market in U.S. bonds has changed the logic of global investment

The most feared scenario for the market was the Federal Reserve’s announcement on March 19 that the waiver to the Supplementary Leverage Ratio (SLR) would expire on March 31 as scheduled and not be renewed thereafter.

After the news was released, three major U.S. stock index futures once plummeted. Financial institutions may continue to sell Treasuries on their balance sheets for fear of taking up capital.

This week, the 10-year Treasury note broke through a new milestone of 1.7% and ended the week firmly at 1.73%. The 40-year bull market that began in 1980 is over, and the yield on the 10-year Treasury note will head above 2% as inflation expectations rise and the economy recovers, institutional commentators say.

In contrast, Chinese bonds are still becoming more attractive to international investors, due to the low correlation with US bonds, the inclusion of international bond indexes and the continued strength of RMB.

It had been widely expected that the Federal Reserve would step in as the government could not afford a sharp rise in yields amid continued selling pressure on Treasuries and a glut of bonds still to be issued.

But in reality, not only was there no intervention, but the SLR exemptions were not renewed, causing the US bond market to crash again.

U.S. stocks fell sharply early Friday, with the most rate-sensitive Nasdaq 100 index leading Wall Street lower, falling 3.1%, its biggest drop in three weeks, and on the verge of breaching support at 12,755. By the early hours of the next day, the VIX had recovered only a modest 0.61%, while the fear index remained above the psychological mark of 20.

What is SLR? This is the capital adequacy ratio index for commercial banks by the Federal Reserve. After the financial crisis, the Federal Reserve modified the relevant provisions of SLR to impose restrictions on the additional leverage of large banks in the United States, in order to prevent banking system risks.

Under Basel III, a minimum SLR of 3% is required for banking institutions with total assets of more than $250 billion and domestic holding companies of foreign banking institutions. Eight systemically important banks, including JPMorgan Chase, Citigroup and Bank of America, will be required to meet a stricter SLR of 5 percent.

This stricter SLR test ran into problems last year after the outbreak hit financial markets. At the time, American businesses and households dumped their assets in search of the safest cash. Leading to a substantial increase in bank deposits, bank deposit reserves climbed significantly. At the same time, the Fed began unlimited QE, injecting liquidity into banks through massive bond purchases, and the big banks’ balance sheets expanded rapidly. When the tier one capital (numerator) of banks remains the same and the reserve (denominator) increases, large banks have no choice but to compress other assets (denominator) such as credit and bonds to meet the assessment requirements of SLR index, which reduces the willingness of banks to lend money and is not conducive to stimulating economic recovery from the impact of the epidemic.

Therefore, on April 1 last year, the Federal Reserve and other regulatory authorities announced a temporary amendment to the rules, allowing depository institutions to calculate SLR without including reserves and US bonds in the denominator, which significantly reduced the pressure on banks’ capital adequacy ratio.

However, this exemption is about to end.

The agency calculates that the leveraged exposure of eight systemically important banks will increase by $21 trillion when the SLR exemption expires in March. In addition, record Treasury issuance and continued QE will add another $2.35 trillion to the financial system’s reserve requirements over the course of this year.

JPMorgan believes that even the worst-case scenario is manageable, with long-term debt of $35 billion, total loss absorbance capacity (TLAC) and Tier 1 capital requirements of $15 billion to $20 billion to maintain SLR in the industry.

Goldman Sachs, however, is more bearish, predicting a $2 trillion shortfall in deposit reserves as the Fed continues to QE.

US 10-year Treasury yields are now above 1.73 per cent, above pre-outbreak levels and up nearly 80BP(basis points) since the start of the year. When the global epidemic broke out in March 2020, Treasury yields briefly fell below 0.4%. It is worth noting that not only nominal interest rates, but real interest rates in the US have also risen rapidly recently, from a low of nearly -1% at the beginning of the year to -0.57% on March 19th

Rising inflation expectations and a recovering economy are leading the charge. In the US, 10-year inflation expectations have rebounded to 2.21 per cent, above pre-epidemic levels, according to break-even inflation data. Core PCE is also expected to peak at 2.5% by mid-year, already above the Fed’s inflation target.

Standard Chartered interest rate strategist John Davis told reporters there could be more profit-taking in the near term, with the 10-year Treasury yield likely to break above 2 percent in the process. Whether it can stay above 2 percent depends on how the U.S. -China trade situation develops, and if risk aversion returns, it could fall again.

Standard Chartered interest rate strategist John Davis told reporters there could be more profit-taking in the near term, with the 10-year Treasury yield likely to break above 2 percent in the process. Whether it can stay above 2 percent depends on how the U.S. -China trade situation develops, and if risk aversion returns, it could fall again.

In that context, 2021 was undoubtedly a volatile year for U.S. stocks, as growth stocks were hit by rising interest rates and value stocks outperformed on expectations of an economic restart.

Institutions generally believe that 2021 U.S. stocks are still a bull market. But Michael Wilson, Morgan Stanley’s chief U.S. equity strategist, previously told reporters that with valuations likely to be squeezed as the economy begins to recover and interest rates rise, with the S&P 500’s price-to-earnings ratio forecast to fall to 20 times this year from nearly 22 times now, higher earnings will be the main driver of stock gains.

For China, the impact of rising Treasury yields is negative. According to Merrill Lynch’s clock, China is entering a stagflation phase where stock market performance will be more volatile as a downturn in the economy leads to lower corporate earnings and rising inflation depresses valuations. “The economy entered this phase in late February and the downward process is likely to last for more than a quarter. In this process, if we encounter A sharp drop in overseas markets, then the length and depth of A-share declines will increase.” Aviation trust macro strategy director Wu Zhaoyin told the first business reporters.

In addition to the analysis of A shares from the economic cycle, but also from the end of the capital research A shares of the flow of funds. He said issuance of public funds had risen sharply over the past year, with average monthly issuance of equity and hybrid funds totalling Rmb270bn and more than Rmb500bn in January. Public funds to raise these funds has become the a-share market main body, promote index rising, and the funds to buy stock mainly concentrated in the food and beverage, medicine, new energy, and other areas of the so-called core assets, these shares several times in A year’s gains, formed the means of stock investment style. But at present, this kind of capital driven logic causes the stock price of the group to fall quickly, but the stock that the fund does not have the key position does not fall significantly.

In addition, last year’s Wall Street consensus for a “weak dollar” has broken down, with traders generally telling reporters that it will be difficult for the dollar to materially weaken until U.S. bond yields stabilize, and that the yuan will look for direction further above 6.5 against the dollar. Still, Chinese bonds will continue to be in demand. FTSE Russell replied to China Business News that it will confirm whether to further include Chinese government bonds at around 6 am on March 30, Beijing time. Standard Chartered expects passive inflows of $130bn – $156bn into Chinese government bonds in the year after their inclusion in the WGBI index from October, if confirmed.

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