Bond Market Vigilantes

After many years in which they were nowhere to be found, now they're everywhere

There’s no hard science on what makes a given stock of government debt unsustainable. A debt ratio of 100 percent to GDP can be perfectly fine as long as bond markets are willing to buy your debt at low interest rates. But if some kind of shock comes along and markets panic, all of a sudden that same debt ratio of 100 percent becomes a problem. In other words, there’s multiple equilibria and we never really know what shifts us from a “good” equilibrium to a “bad” one. That’s largely up to markets, i.e. people and sentiment, which - for our all our advances in economic modeling - the economics profession still has a difficulty capturing.

Since we don’t really understand what makes bond market vigilantes come out of hiding, the next best thing is to track - at high frequency - what’s going on in bond markets. That’s what I’ve been doing in recent posts, starting with the US and then on a broader G10 perspective. What’s clear is that there’s a buyers’ strike at the very long end of yield curves all over the place. This is impacting some places more than others - Japan and France are the hardest hit - but longer-term yields are rising everywhere. The global dimension of what’s going on is in my mind a delayed reaction to the rise in global debt during COVID, when policy makers were still convinced that interest rates (and inflation) would always be low. It doesn’t help that certain places - notably Japan - have kept long-term yields artificially low via central bank QE. As the Bank of Japan tries to disentangle itself from this, longer-term yields in Japan are going crazy.

The panel of charts gives a snapshot of what’s going on in global bond markets. Every chart shows the 10-year government bond yield in blue as well as the 1020y forward yield in red. The latter is the 10-year yield in 20 years’ time that’s priced into the very long end of the yield curve. I back this out from 30- and 20-year government bond yields. The advantage of this measure is that it abstracts from short-term, cyclical variation, which can make things look better than they really are. The current juncture is a case in point. US recession fears are pulling down the 10-year Treasury yield, which makes the US bond market look ok. But when you look at the 10y20y forward yield, that’s staying stubbornly high, so the true picture - beyond short-term cyclical variation - is quite a bit more worrying.

There’s a huge amount going on in global bond markets at the moment, so let me summarize what I see as the key points:

• The rise in very long-term yields is global. The rise in 10y20y forward yields versus 10-year yield is happening everywhere. The only exception is Switzerland, which I return to below. There’s thus a global buyers’ strike of government debt at very long tenors, which is likely a delayed reaction to the massive debt run-up during COVID and continued, massive deficits in many places.

• Japan and France look most vulnerable. The disconnect between 10y20y forward and 10-year yields is most prominent for these two countries. For Japan the driver is policy driven, with the Bank of Japan trying to disentangle itself from decades of QE, which is sending longer-term yields shooting up. With debt at 240 percent of GDP, my bias is that this repricing still has a long way to go. France is about recent efforts to get the budget under control, which is causing political ructions. It’s worth noting that the UK doesn’t look especially bad in this cross-country perspective. I’ll return to this point below in tomorrow’s post, but the bottom line is that the UK has always had more volatile longer-term bond yields, so what’s going on now isn’t as much of an outlier as Japan or France.

• The universe of safe haven countries is shrinking. It used to be the case that Germany would see a minimal spread between 10y20y forward and 10-year yields at times of heightened uncertainty, as global markets bought Bunds and pushed German longer-term yields down. That’s no longer happening. In fact, one of the very destabilizing features in this bond market sell-off is that two notable safe havens - Germany and Japan - have fallen by the wayside. Only Switzerland remains, which means that - as global markets plow into this one safe haven - its 10y20y forward yield has fallen to almost zero, which is remarkable. The reward for being a low-debt country has gone up substantially in markets.

So there’s multiple forces at play currently: (i) markets are digesting the debt hangover from COVID, a situation that’s exacerbated by the fact that deficits remain extremely wide all over the place; (ii) there’s a number of idiosyncratic stories where things look especially worrying, which is France and Japan; (iii) the world is losing traditional safe havens, most notably Germany, so there’s fewer places for investors to hide. The bond vigilantes have definitely come out to play. Many years of reckless fiscal policy coupled with artificially low long-term yields are giving them lots to play with.