The impact of QE in particular on holding down bond yields is less clear than sometimes claimed
The recent decline in bond yields has done little to ease concerns about chronic US fiscal deficits. The country’s latest first-class AAA rating has a negative outlook, i.e. can be lowered.
Worries of a potential doom chain as rising deficits force governments to borrow more and raise interest rates to attract debt investors are mounting, writes Matt King, founder of Satori Insights and former global market strategist at Citi, for the FT.
What might seem obvious—that increased borrowing leads to higher bond yields—turns out to be at odds with historical data, he points out.
Higher levels of government debt in advanced economies have almost always been associated with lower bond yields, not higher. This discovery is not limited to the USA: it applies to Germany, Italy, Japan, Great Britain, Switzerland and Australia back in time to the 1980s.
If we look at fiscal deficits, perhaps a fairer test of the impact of the actual borrowing process, the picture remains profoundly counterintuitive. On annual or longer-term changes, for every case where it looks like increased borrowing may have led to higher earnings, there’s at least one where the relationship looks more like the opposite, writes Matt King.
There are three reasons—two empirical and one theoretical—why this phenomenon has persisted historically and is likely to persist in the future. The first is financial repression, where governments and central banks reduce yields. During eras of particularly high debt, governments use every tool at their disposal, from quantitative easing to accounting regulations and capital controls, to help minimize their financing costs.
The relationship between higher debt and lower bond yields holds even in jurisdictions and periods when financial repression is not widespread. The impact of quantitative easing, particularly in holding down bond yields, is less clear than is sometimes claimed. The same applies to the perceived impact of the reverse process — quantitative tightening, as yields rise.
The second, more powerful argument was advanced by US Treasury Secretary Janet Yellen. Economic strength and future interest rate expectations, not deficits, are the main drivers of bond yields. In reality, the relationship between yields and deficits is usually negative: deficits and debt tend to fall during periods of economic growth when bond yields rise, and rise during recessions when yields fall.
A large supply makes government bonds cheaper relative to interest rate swaps, but that is very different from boosting yield levels.
The third reason why large deficits are not associated with high bond yields is that, counterintuitively, most borrowing is much closer at the systemic level to self-financing than is widely recognized. You don’t need to work in the syndication department of an investment bank to see the inherent logic in saying that “someone has to buy” every bond issue. This usually involves a private investor withdrawing deposits from their bank account.
Provided that the proceeds from the bond sale are eventually spent in the real economy, they lead to an increase in bank deposits that offset the amount that the private investor withdrew for the purchase. Total bank deposits – or tight money – remain unchanged.
Stranger still is the effect on broad money or credit. The very process of borrowing creates money, at least in the broad sense of general credit, out of thin air. This is true not only when borrowing is financed by bank lending, but also when it is financed by the bond market. This is also why aggregate borrowing correlates better with asset prices than with bond yields.
None of this justifies unlimited deficit spending. As the Liz Truss government in the UK has shown all too clearly, there is a point at which deficits matter and indeed have the intuitive effect of increasing yields. Fiscal crises in bond markets are more likely to start with sudden collapses in confidence, the importation of inflation and currency outflows, Matt King points out.
He concludes that finance is a non-linear subject. The long-term unsustainable can often turn out to be surprisingly investable in the short-term, King adds.