The bond market has entered a new world, rewriting the rules on what drives yields higher, economist says

• The bond market is entering a "new world" where supply affects bond yields, T. Rowe Price's chief Europe economist said.
• Central banks were top buyers of bonds, but many shifted to quantitative tightening.

Across the world, many major economies are pumping the brakes, and that's warping a basic dynamic in the bond market, according to T. Rowe Price's chief European economist.

While popular theory argues long-term interest rates are just the average of future short-term interest rates, with the supply of bonds not a factor in setting yields, Tomasz Wieladek said "that is not the state of the world we are in today."

That's because the bond market is missing its biggest buyers: central banks.

For the past decade, central banks had been the top buyers under quantitative easing campaigns that began with the financial crisis, Wieladek wrote in an op-ed for the Financial Times.

"For all these reasons, the private sector had only to absorb a trickle of sovereign debt issued, even during the height of the Covid-19 pandemic when a huge rise in public sector deficits was accompanied by a massive increase in QE," he explained.

But in the last year, major central banks are now in quantitative tightening mode and no longer sucking up bonds, just as governments are issuing massive amounts of debt.

In fact, all G7 governments are selling a glut of bonds at the same time, Wieladek added. And without central banks, who are less sensitive to returns, the bond market is dictated more by investors who are more sensitive.

"In this new world, bond supply can affect the level of yields through term premia," he argued. "A rise in outstanding bonds will raise the share of private sector ownership, as central banks are not in the market any more. But private sector investors have many other options when it comes to purchasing bonds. So yields have to rise to become more attractive."

As an example of the influence private investors are now wielding in the bond market, Wieladek pointed to a recent Treasury bond auction that saw weak demand.

The US sold $20 billion of 30-year bonds, but dealers had to take up more supply after investors balked. That sent long-term yields sharply higher.

A subsequent auction saw improved demand, but massive federal deficits going forward mean the US must continue flooding the bond market with fresh debt.

And Wieladek noted that expectations of future large bond supply effects the term premia, or the extra return for investors for taking on interest rate risk over longer periods.

In the UK and US, term premia are already at pre-financial crisis levels, but they could easily climb even higher due to the large supply of bonds, quantitative tightening, and investor caution, he warned.

"Governments and investors need to be aware that in current circumstances, bond issuance is an important determinant of yields."