Why Are Global Bond Yields Rising?

Stephen Kirchner recently surveyed a number of explanations for the sharp rise in US bond yields. His account draws partly on published commentary and partly on private correspondence, including an argument from macroeconomist Dimitris Valatsas. Kirchner starts with five contending theories.

• US fiscal deficits / Treasury supply: large government borrowing increases the supply of Treasuries and the demand for global saving.

• Foreign abandonment of Treasuries: foreign investors, particularly official holders, may be reducing their willingness to hold US government debt.

• The AI investment boom: large AI-related capital expenditure creates additional private demand for financing and competes for global saving.

• Fed/Treasury communication and policy expectations: changing expectations about monetary policy and official policy signals may have pushed longer-term yields higher.

• A higher r*: the return on technology capital has risen substantially, increasing the demand for capital and pushing up the natural rate of interest, r*.

Kirchner notes that Robin Brooks is sceptical that foreign investors are abandoning Treasuries and equally sceptical that the AI investment boom is responsible. Brooks emphasises the US fiscal deficit instead, arguing that government dissaving is the principal source of pressure on yields. I think Brooks dismisses the AI explanation too readily. I find Valatsas’s argument regarding r* persuasive, up to a point: where I part company is confidence rather than mechanism.

Kirchner is focused on the recent rise in US Treasury yields. I want to start with a broader question. How much of the movement is American and how much is part of a global repricing? Bond yields have risen substantially in Australia, the UK, Germany and Japan as well as the United States. That matters for identification. An explanation specific to the United States may explain the additional rise in Treasury yields, but by itself it cannot explain a common movement across global bond markets. The starting point here is therefore the global component, before turning to what is specifically American.

And there is something missing from the explanations of that global movement. Today’s yields are being compared, implicitly or explicitly, with a post-GFC world in which central banks became enormous, price-insensitive buyers of government bonds. That source of demand has largely disappeared. Governments remain large borrowers, a major new private investment cycle has emerged, and the global environment has become substantially more uncertain.

Australia has a problem or two

Working-age population growth is running at about 1.7% a year, while potential output growth is only around 2%, largely because productivity growth is close to zero.

The TWI and monetary policy tightness: part 2

In 2017, the RBA cash rate was just 1.5 per cent. Today it is 4.6 per cent.

Look only at those numbers and monetary policy today appears vastly tighter. But that comparison misses an important part of monetary transmission in a small open economy: the exchange rate.

A higher Australian dollar makes imports cheaper and Australian production relatively more expensive. It lowers imported inflation and shifts demand away from domestic production. A lower dollar works in the opposite direction.

The difficulty is that the Australian dollar moves for many reasons besides monetary policy. Commodity prices are particularly important. A high dollar during a commodity boom does not necessarily tell us that Australian monetary policy is unusually tight.

So can we separate the two?

I estimated a simple long-run relationship between Australia's real trade-weighted exchange rate and commodity prices. The residual gives us a way of asking a useful question: is the Australian dollar unusually expensive or cheap given the commodity prices Australia faces?

The answer produces an interesting history of Australian monetary conditions. It also helps explain how a cash rate of 1.5 per cent could have been too tight in 2017, while a cash rate of 4.6 per cent today does not, by itself, tell us how tight monetary policy is.

It's a brave new world

We are moving from a world that, first with the rise of China in the noughties and then global QE, had a surplus of savings to one with a more normal supply of savings and much stronger demand for investment. Think the AI build-out and large unfunded US fiscal deficits.

Bond yields are rising as the world adjusts to a higher cost of capital. They could rise significantly further, particularly if risk premia increase; yields are well below 1990s levels. But they do not need to rise further for the adjustment to bite: the longer yields remain at these levels, the more cheap debt is refinanced at today’s higher rates. Many business models that worked in the cheap-money era will no longer work.

Asset valuations (stocks) will have to adjust too. Typically, when bond yields rise, stock valuations fall.

The TWI and monetary policy tightness

One of the better guides to whether Australian monetary policy is actually tight is the trade-weighted Australian dollar.

The TWI summarises the value of the Australian dollar against the currencies of our major trading partners. For a small open economy like Australia, the exchange rate is one of the most important channels through which monetary policy affects inflation.

A higher dollar makes imports cheaper. It also makes Australian production relatively more expensive, weakening export demand and increasing competition from imports. Both reduce inflation.

But the exchange rate responds to Australian interest rates relative to rates elsewhere, not simply to the cash rate.

Australia’s current account deficit is back. Should we care?

Australia is a current-account deficit country again. Thirty years ago that sentence would have led the evening news. Today it barely rates a mention.

The silence has a history. In the 1990s an ANU economist, John Pitchford, won an argument that the current-account deficit was not a policy problem. His view became the official view. This post recaps that argument, and then asks whether it still offers comfort. I think it does not, and on Pitchford’s own terms.

The Fragile Equilibrium

Each month I have been reflecting on the war in Iran. In August I described the Iran war as a morass. It still is. But something important has changed.

America appears to have found a way to live in it.