Debunking Bond Market Sell-Off Myths

Everything you need to know about the sell-off, from shadow yields to Dollar shortage

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I’ve been writing a lot about the global debt overhang and rising long-term yields. This has been a market theme ever since COVID for three reasons: (i) the pandemic saw governments everywhere run huge budget deficits, resulting in a debt issuance frenzy that was unprecedented; (ii) deficits never returned to “normal” after COVID, but remained wide, so - whatever vestige of fiscal discipline remained - went out the window with the pandemic; and (iii) inflation has turned out to be much more volatile - and higher - than the pre-pandemic consensus allowed, which means central banks are hiking more frequently and aggressively to keep inflation expectations anchored.

Nothing here is new. All these things have been know for some time, but markets are really moving this week. At times like these, there’s lots of misinformation. This note runs through what’s happening and debunks myths and nonsense.

• The truth about rising yields: there’s two things going on in bond markets. First, there’s a broad rise in long-term government bond yields. The chart above shows 30-year yields, which have risen steadily since COVID. The latest rise is about higher oil prices and geopolitical uncertainty and will reverse at least partly when the war with Iran ends. This part of rising yields is therefore temporary. Second, some yields are being kept artificially low by central banks. The poster child for this is Japan, where the Bank of Japan is constantly buying government bonds to cap yields, which is how you end up with the crazy chart below: Japan’s 30-year yield is barely higher than Germany’s, even though its government debt is far higher. Yield caps aren’t just a thing in Japan. The ECB is also guilty of doing them for high-debt countries like Italy and Spain. Such caps conceal what the true yield would be without central bank intervention - the “shadow yield” - and are politically unsustainable. This is why the current bond market sell-off is radiating out from Japan and this is a force for yields to rise more permanently. Basically, artificially low yield levels are falling by the wayside.

• The rise in yields is orderly: at times like these, there’s lots of talk that markets are becoming dysfunctional and that price action is disorderly. That’s not obvious from available data on market functioning. Bloomberg’s measure of bond market liquidity shows deteriorating liquidity, including for Japan, but it doesn’t look like things are falling apart in a disorderly fashion. Instead, what’s happening is a repricing, i.e. price discovery. That’s what markets are supposed to do.

• There is no Dollar shortage: I’ve been hearing talk of Dollar shortages, which can happen at times like these, but there’s no sign of this whatsoever. The chart below shows the one year cross-currency basis for the Euro (blue) and Yen (black). It’s clear that shocks like the Euro zone sovereign debt crisis or COVID saw a severe USD shortage, but there’s no sign of that right now. There is no Dollar shortage.

• The US’ exorbitant privilege is stable: the chart below compares the US 10-year yield to 10-year yields abroad after those have been swapped back into Dollars using FX forwards. It’s true that the US used to issue 10-year sovereign debt more cheaply than its G10 peers and that it lost that privilege just before COVID. But there’s no sign that things have deteriorated recently. The US is issuing around ten basis points above the G10 Dollar-equivalent yield. The current bond market sell-off isn’t about the US losing attractiveness relative to its peers.

• Rising yields are good, not bad: only if markets are allowed to push up government bond yields freely will governments ever take action to get fiscal policy under control. The UK gets painted as a fiscal basket case these days as its yields have risen faster than elsewhere, but this is merely a function of the Bank of England refraining from yield caps, unlike elsewhere. Besides getting policy makers to do the right thing, this also means risk premia are adequately priced in UK yields, so markets don’t head for the exit like they do in Japan. Artificially low yields in Japan just put depreciation pressure on the Yen, which is why it’s falling (left chart below), while higher UK yields have allowed the British Pound to be stable in trade-weighted terms (right chart below). If you suppress risk premia in the bond market, they just show up in the currency. Better to be transparent and allow yields to send the required signal to policy makers.

The bottom line is that the rise in yields that getting so much attention this week isn’t new. It’s been ongoing since COVID as markets recognize that high sovereign debt levels and unstable geopolitics require bigger risk premia. Not all of this repricing is permanent. A rapid conclusion to the war with Iran will see yields fall a bit. But there is a permanent force for yields to go higher, which is that central banks in many places artificially kept yields low. Such yield caps are politically unsustainable and will fall by the wayside. That’s a force for yields to go structurally and permanently higher.