“Safe Asset” Sensitivity
When the marginal buyer is price insensitive, a market can produce really silly results. When the global economy is structured to rely on the rationality of this marginal buyer, capital allocation is dramatically distorted when he is no longer rational.
Central banks pursuing quantitative easing buy assets with duration (long-term assured cash flows). They replace them with cash, $5tn so far, which has zero duration. Simultaneously, regulation increases demand for “safe assets”. QE leaves precious little for the rest of us. The G4 supply of “safe assets”, net of debt repurchases, should total negative $300bn this year, we estimate, compared with an annual run rate of $3.5tn before the financial crisis.
The result? Abnormally low yields and highly correlated price changes in bond markets, both up and down. Less well-documented is the demand for these high-quality liquid assets, which include government debt and top-rated corporate bonds. Strategists baffled by the seemingly paltry compensation for holding government paper assume this is a momentum-driven trade that will end suddenly. Market action in recent weeks supports this belief. This ignores the huge demand for high-quality liquid assets from two groups of buyers that are wholly or partially insensitive to price.
The first, life insurers and foreign exchange reserve funds, have limited discretion as to when and how to roll over their balance sheets. European insurers are working to comply with the new capital requirements of Solvency II. Reserve managers are constrained by sovereign risk considerations in their asset choices to a material extent (two-thirds of their combined $12tn balance sheet, we estimate). These price-insensitive buyers have some $40tn of assets under management. Even with a decline in foreign exchange reserves this year, the first in the past 20 years, they require an additional $3.5tn more each year to reinvest the proceeds of their maturing bonds, we estimate. And this is just to stand still!
The second group has some discretion when it comes to price and asset choice. This includes pension funds seeking to cap liabilities; endowments striving to meet spending rules without taking excessive risk; property and casualty insurers; and banks increasing levels of “safe” capital. This group manages some $20tn of assets, we estimate. They have to reinvest some portion of their balance sheets or risk an increasing mismatch between assets and liabilities. They try to balance the risk of waiting too long to buy with the natural instinct to pass on outrageously high prices — while praying for a back-up in yields. Our best guess for this group’s minimal reinvestment needs is $500bn a year. Together these two groups have reinvestment needs of $4tn of high-quality liquid assets a year. Supply, however, is estimated by us at just $700bn this year. This includes an estimated $1tn of new investment grade corporate bonds and a negative $300bn from governments. This creates a shortage of high-quality, liquid assets of $3.3tn.