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.

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.

What a Real Bond Crisis Looks Like

People throw around the word "crisis" every time yields move. It's worth being precise about what that word actually covers, because the different versions call for completely different responses.

Markets reprice all the time as new information arrives. That's their job. A repricing on its own is not news. What matters is the size of the move, the speed of the move, and whether anything underneath the market itself is breaking. Those questions are what separate the ordinary from an actual crisis.

US Bonds Crisis

Everyone is panicking about the US bond market. Here is thirty years of data on the thing they are panicking about.  

Why is the Aussie dollar so strong?

Australian productivity has gone backwards since 2019. Unit labour costs are running ten points above the United States from a common base. The goods trade balance in trend-terms has fallen from above 13 billion dollars a month at the 2022 peak to barely 3 billion, with the latest print briefly negative. Inflation has reaccelerated above the target band on every measure. By any fundamental read, the Australian dollar should be weakening. It isn't. It has rallied from briefly below 0.60 last year to above 0.72 now and the trend is looking up.

The answer is the interest-rate differential. Everything else is detail.

Bond market normalising?

I have been tracking inversion in the medium to long-term bond markets as a broader indicator of market nervousness. My latest read suggests a significant unwinding of tension.

I'd love to know what is happening here. I am wondering whether foreign demand for aussie bonds has evaporated (ie. I was not measuring local nervousness in the first place).

Normal service is returning ...

With the roll-out of QE3 in the United States and OMT in Europe my indicator of market nerves (cumulative bond yield inversion) has been unwinding.

The other good news is the rebound in the Baltic Dry Index over the past week.

More gloom - but it looks cyclical not structural

What an interesting week. Many Australians woke up this week to the realisation that the mining boom just might have bust. In Canberra, it looks like we are facing new rounds of austerity and downsizing. But not to worry, this spring house prices are set to spring back.

And on my gloom indicator (using data from RBA table F2), we reached a new post-GFC peak with Friday's data. But there is a little silver lining to these storm clouds. We will come to that in a moment.

Not so long ago, I said I would worry about this when it reached 20 points. Well it is at 20 points and I am not fully worried. I would say that I am alert but not (yet) alarmed.

In the last week, there has been an interesting debate in the blogosphere about Australia's economic outlook. The central question in this debate is whether the current downturn in China is cyclical or structural. The macro-bears tick the box marked structural. They think we are going to hell in a hand basket. The China boom is over. Go straight to jail. Do not pass go. Do not collect $200.

The bulls think the worst we are in for is a tight time. China will slow a little and rebalance, but inevitably its demand for iron ore and coal will pick up, perhaps before Christmas.They argue that China is only one-quarter the way through its development trajectory and there is a long development path ahead necessitating years of Australian exports.

So where do I sit. If inversion in the bond market reflects the wisdom of crowds, its nervousness is at the cyclical end of the spectrum. The inverted rates only go out as far as three years, but not five years. In the worst of the GFC build-up, yields were inverted out to ten years. At worst, the bond market sees a short to medium run problem, a couple of years max, not a long run problem.

Let's look at the graphs. In each of these graphs I take the yield rate for one period and subtract the yield rate for the next period. All other things being equal, long-term bonds carry more risk than short-term bonds from the same agent. As a consequence, investors typically expect a greater yield on long-term bonds than short-term bonds. In these charts, that results in the blue line being below the origin. When the blue line is above the origin, it means that investors see less risk in buying longer term bonds compared with shorter term bonds.

But like everything economic, there are competing analyses.

On the one hand, the inversion in the 3-2 graph above may simply reflect European storms. Other nations are using the Australian government as a safe haven in their time of trouble. The demand for three year bonds may be saying more about foreign affairs than the Australian economy. Indeed, without this external demand there may not be much inversion at all.

The story from the other hand would note the degree of inversion in the short run (on the 3-2 graph above) is currently higher than it was with the run into the GFC. The bears would say that even if I am right about only needing to fear a short downturn, it's going to be deep and feel like I have been whacked in the head with a frying pan.

Usual caveat: I am not a financial advisor and this is not financial advice.

And back to post-GFC peak gloom

Gloom see-saw tipping towards more gloom

It looks like we are entering the pessimistic end of the cycle on Australian bond markets. My indicator of yield inversion in the medium to long term bond rates suggests another round of pessimism is setting in. (Data from RBA table F2)

Gloom on, gloom off

There is an old army saying: 'Great coats on, great coats off'. Apprently this saying captured the mindlessness of army life: being sent in one direction in the morning only to have the order countermanded with the opposite direction in the evening.

The markets are a bit like that at the moment with gloom. Some days they are awash with optimism and on other days it is pessimism. You could say it is gloom on, gloom off.

According to my gloom indicator, we are moving into the gloom off part of the cycle.

Gloom

My gloom indicator continues to grow (albeit with a down tick in the last read).

So far (in this post GFC period), all of the movement in this index has been in the inversion between 2 and 3 year bonds. In the next two plots, I compare an index built on three comparisons (2-3, 3-5 and 5-10) and one that accumulates two comparisons (3-5 and 5-10). You can see in the second plot that nothing is happening in the latest period.

What is interesting is that while five year bonds continue to have a higher rate than three year bonds, they no longer have a higher yield than two year bonds. In the next chart we compare five and two year yields. A positive read shows an inversion. 

Just for completeness, the 2-3 and 3-5 yield gap charts follow.

Even more gloom

My gloom indicator (details in the comments here) keeps lurching upwards. Note this is the same indicator, but measured in basis points (rather than percentage points as it was previously).

If it gets to 20 basis points, I think I will become officially worried.

The longer run graph follows ...

More gloom

Regulars here know that I track the cumulative level of yield inversion in the bond rates at 3, 5 and 10 years. I use this inversion index as a rough barometer of market gloom.

Today's reading has inched up another notch to another post-GFC record.

Click on the bonds label below to see previous reports on this indicator.

Market gloominess indicator up again

For some time I have been tracking the cumulative inversion in 3, 5 and 10 year bond yields as a general indicator of gloominess in the market's assessment of our future economic performance. The latest read from this indicator is at a new post GFC high.

But let's put this latest spike into context of the readings prior to the GFC.

If you take the long view, there is a whole host of issues to think about. For starters, how long can the Euro-zone keep kicking the can down the road before grasping the Spanish and Italian nettles? Has China hit structural growth constraints (noting there is a host of possible constraints to consider: capital, labour, an ageing population, world demand for its exports, internal inflation, pollution, etc.)? For how long can markets forgive the US sovereign debt (and can the US' gridlocked political system ever address the problem)? Will global household deleveraging lock in a low-growth global future for decades to come? Is a long-run return to global inflation/stagflation inevitable given the many rounds of QE? What if monetary policy stops working? Locally, what does it mean for our economy now that we may have passed peak terms of trade (after an amazing 2001-2010 ride compared with the 1960-2000 period)?

Market nerves

I track the cumulative inversion in 3, 5 and 10 year bond yields. I use it as a rough indicator of market nervousness. Today's reading sees my indicator dialing up again.

Last time I looked at this we had a great Greek election and the Spanish banks had just been rehydrated. Things were settling down.

So what is going on now? Could it be fears of a new global slowdown: Europe is fading fast, China is slowing and the US is flat? Or is it financial heroin withdrawal symptoms with the Federal Open Market Committee’s June decision not to grab the hypodermic labelled Quantitative Easing Mark III?

Settle petal

My "market nerves" indicator is settling down a bit. We have had a good Greek election. Spanish banks have been re-hydrated. Normal boom services will resume shortly.

A growing market nervousness

I have been monitoring inversion in the medium to longer-term bond yields. Today's print sees my index of nervousness continue to creep upwards. It is now significantly higher than it has been any time since the global financial crisis.

Treasury Bond Yields

More market nerves

My crude long-term inversion index has climbed further ... data from RBA table F2 ...