The Lurking Global Debt Crisis

Geopolitical uncertainty means the world needs fiscal space - but there is none

A few months ago, I wrote a series of posts about the worrying rise in longer-term government bond yields, which have decoupled from shorter-term yields and risen to a worrying degree. My central argument was that the 10-year yield can be pulled down by front-end yields if markets expect central bank rate cuts, so - if you want a cleaner picture of what’s really going on - you should look at the 10-year yield 10 years or 20 years forward. This post updates the charts I first put out then, which compared the 10-year yield with the 10-year yield 20 years forward across key advanced economies.

This perspective is especially important at moments like this. The oil shock that’s unfolding - and the geopolitical uncertainty that underlies it - are fiscal shocks that require governments to spend more, most notably on defense. The problem is that fiscal policy has been out of control for so long that many countries have exhausted their fiscal space. This is why central banks all over the place are under mounting pressure to cap yields - Japan is the prime example - and why every shock is these days accompanied by calls for joint debt issuance in the Euro zone.

Every chart above has the same format and the same scale. The blue line is the 10-year government bond yield, while the red line is the 10-year yield 20 years forward, which I back out from 20- and 30-year bond yields. Three points are worth making:

• The decoupling in long-term yields is global: the COVID shock was unique in that many countries did unprecedented fiscal stimulus at the same time. The global decoupling in the 10-year yield 20 years forward from the simple 10-year yield is a reflection of that. We used up a lot of fiscal space during the pandemic. As uncertainty rises and spending needs go up, it makes sense that markets demand higher long-term yields all over the place.

• The decoupling is especially pronounced for some: Japan looks most worrying, especially once you factor in that the Bank of Japan is still a large buyer - on a gross basis - of government bonds. The UK and key Euro zone economies like Germany, France and Italy also look concerning.

• The list of safe haven countries is shrinking: Switzerland is the only place where yields are incredibly low and there’s no decoupling of the 10-year yield 20 years forward from the simple 10-year yield. In a world where debt is running out of control, the rewards to low debt countries in terms of low and stable yields are enormous. There’s never been a bigger reward for responsible fiscal policy.

The oil shock we’re currently experiencing will push up inflation and will surely exacerbate pressure on central banks to cap yields. It’s worries in this regard that have driven the “debasement trade,” which has its most obvious manifestation in crazy gains in precious metals over the past year. That points to a mounting crisis of confidence. A global debt crisis is lurking just around the corner.