The central banks of Japan, the Eurozone and the United States hold major sovereign bonds portfolios. This represents 20% of GDP in Japan, 18% in the Eurozone and 12% in the United States. Since acquiring sovereign bonds is not part of the central banks’ mission, why are they doing it? Mostly, because it serves the countries. They have to finance their deficits, thus they have to find buyers, locally if possible, that they know and on whom they can exert a certain influence.
How? As an example, the backstops negociated in Basel stipulate that, when a bank makes a loan to a business, it must keep some liquidities as collateral. But, on the other hand, it doesn’t have to freeze any cash if it buys sovereign bonds from a well-rated country! So, why bother with lending into the economy when they can make as much with these bonds? Generally speaking, the large indebted countries have developed relations with their big banks that may be qualified as incestuous. Since a good many of them have been saved from bankruptcy in the 2008 crisis, they’re easily convinced of participating in their own bailing out...
We are right in the midst of a self-perpetuating mechanism in closed circuit or, in other words, that is inducing a bubble. The bond bubble is not just a concept. Everything could go on for quite a while if interest rates were to stay low. And, precisely, we’re seeing a generalized hike on the rates, not only in battered countries, but also in Germany and the United States. The reasons for such a hike are many : expansionary monetary politics end up generating high inflation anticipations, the continuing crisis makes for a higher risk premium, the projected « recovery » isn’t happening... And, as we know, higher interest rates cause a decline in the value of bonds portfolios, which in turn creates losses of capital value, thus less money for the banks.
The Natixis Bank did the math on what higher rates would mean for the banks’ balance sheets. Supposing all bonds portfolios are priced to market, a 1% hike on long-term interest rates would reduce actual banks’ funds by :
14% in the Eurozone
16% in the United States
160% in Japan.
For Japan, this is not a typo. This result comes from the size of their portfolio combined with their lack of proper funds. The situation is thus untenable in Japan and can only be contained in the States and the Eurozone if rates go just slightly up. The ten-year Treasury bonds were yielding 2% before the recent hike, but let’s recall that they were yielding 6% in 2000 and 8% in 1990, so those are numbers we should keep in mind. In any case, the cost of rate hikes will be quite severe for the banks’ proper funds... and these funds are there to cover all kinds of other risks...