Which Countries are out of Fiscal Space?

Bond markets signal the biggest vulnerabilities for Japan, the UK and the Euro periphery

In the decade before COVID, inflation was stubbornly subdued, encouraging the illusion that central banks would always be able to keep rates low and - therefore - that governments could run up lots more debt without interest expense running out of control. The most extreme manifestation of this is Modern Monetary Theory, but this line of thinking has inflected fiscal policy broadly, which is why budget deficits all over the place are wider than before COVID, even though the pandemic has passed.

The illusion of ample fiscal space collided head-on with the post-COVID inflation shock and a rise in spending needs due to Russia’s invasion of Ukraine, US tariffs and now the spike in oil prices. This has pushed up long-term government bond yields all over the place, but - because the rise has been global - it’s hard to see which countries markets are especially worried about. That’s my focus today. I make trade-weighted 30-year government bond yield differentials to isolate where yields are up relatively more. Japan is in trouble, as is the UK and much of the Euro periphery.

The left chart above shows monthly data for 30-year government bond yields for the US (black), the Euro zone (red), Japan (blue), the UK (orange) and Switzerland (pink). The Euro zone yield is a GDP-weighted average of countries in the currency union. This is misleading because it makes it look like there’s a fiscal union when there is not, but I need some Euro zone aggregate to make trade-weighted yield differentials. My readers will be familiar with my views on the Euro zone, where I think the ECB has been co-opted by high-debt countries to institute de facto yield caps, without which much of the Euro periphery would be in crisis.

The right chart shows the corresponding 30-year yield differentials, where I use the same trade weights each central bank uses for its trade-weighted currency index. A couple of points are worth making. First, the UK has the highest differential, so has the biggest problem. What’s interesting is that its differential jumped during the LDI blow-up in 2022 and never normalized. A permanent risk premium has been priced in and is gradually growing. Second, as much as Japan’s differential has risen, it remains negative and far below most other countries. This - in a nutshell - is why the Yen is so weak and in my opinion will keep falling. Japan’s long-term yields are still far below where they should be given the monstrous level of public debt. Third, without ECB yield caps with things like the Transmission Protection Instrument (TPI) and verbal as well as actual intervention, much of the Euro periphery plus France would have long-term yields in the double digits. I’m glossing over that here, but the reality is that - without the ECB - much of the Euro zone would be in severe crisis.

It’s endlessly vexing to people that US yields are so well behaved with everything that’s going on. The reason is that so many other places are in far worse shape than the US. The US is the cleanest shirt in the hamper.