Fiscal policy is driving bond yields higher in some developed economies
- Why are bond yields so high for developed countries? One possible reason is that fiscal probity appears to have weakened. Many countries currently have historically high debt levels and deficits compared to their gross domestic product. Moreover, this is happening despite the lack of a crisis, which is normally the time when fiscal probity come under greater pressure.
Why is this happening? First, deficits are, in part, due to demographics. That is, almost every major developed economy is currently facing rising costs of servicing the needs of an older population through pensions and healthcare.
For example, in the United States, the number of people receiving retirement benefits from Social Security has risen from about 31 million in 2000 to 56 million today—a trend that is likely set to continue. Absent tax increases, offsetting spending cuts, or accelerated economic growth, such pressures could keep the deficit elevated.
Second, in most developed countries, there is an increasing consensus on the need to spend more on defense—especially following the Ukraine-Russia conflict and questions surrounding the North Atlantic Treaty Organization and other alliances—which will likely exert further fiscal pressure on their economies.
Third, many countries are facing political fragmentation, which can make it increasingly difficult to reach a consensus on how to address fiscal imbalances. In the United States, for example, significant changes to taxes, defense spending, or things like Social Security or Medicare, have often proven politically difficult to enact.
Finally, the decades-long period in which borrowing costs were historically low appears to have largely ended. The rise in borrowing costs came about following the pandemic, when governments significantly boosted spending, and when supply-chain disruptions led to much higher inflation. Today, borrowing costs are high and could go higher depending on a variety of factors such as inflation, monetary policy, and confidence in fiscal policy. And higher borrowing costs also exacerbate deficits.
The challenge now is that, if governments do not take credible steps to restore fiscal probity, borrowing costs could rise further. Moreover, when the next economic crisis comes (and it will come eventually), governments might not have sufficient fiscal space to respond in a way that does not cause a further rise in borrowing costs.
- In the United States, government borrowing costs have increased sharply, with the yield on the 30-year bond hitting its highest level in two decades. This suggests that investors are seeking additional compensation for perceived risks associated with holding long-term government debt.
- Even the US government—while intervening in the currency market to support the Japanese yen—did not sell US government bonds. Rather, it sold euros to boost the yen. This suggests that there was concern that the selling of US dollars could boost US borrowing costs further.
What is notable is that, even with inflation appearing to decelerate and with some evidence that the economy is slowing (slow employment growth and slow retail sales growth), bond investors still expect higher returns. Moreover, expectations for monetary policy have shifted, with investors now seeing a high probability that the Fed will not raise rates in September and a high probability of only one rate hike before the end of the year. Despite the shift in sentiment toward a less tight monetary policy, investors want to be compensated for the risk of holding government bonds.
What does this tell us? One interpretation is that investors are likely not focusing on inflation expectations, monetary policy expectations, or even economic growth. Rather, they are focusing on fiscal policy. That is, it could be the case that they are increasingly worried about the unusually large budget deficit. Plus, they might be concerned that neither major political party in the United States is having a serious discussion about reining in the deficit.
The rise in government borrowing costs is already influencing US economic conditions. Mortgage interest rates have risen to their highest level in a year. Considering all else remains the same, this could dampen activity in the housing market. This is also an example of what Fed Chair Warsh suggested, that is, markets will do the work of the US Federal Reserve by adjusting borrowing costs on their own.
The implication is that the US Fed does not need to do anything. Plus, if borrowing costs are rising primarily because of concerns around fiscal policy, the Fed’s ability to directly address those concerns may be limited. All it can do is adjust policy in response to inflation and employment data. If, however, fiscal policy contributes to a sharp rise in yields, which, in turn, suppresses economic activity, the Fed will likely have to absorb that information into its future deliberations.
- In Japan, Prime Minister Takaichi intends to boost government investment by about US$2.3 trillion in the coming years. This is meant to fund investments in key technologies, the goal of which is to boost productivity and, consequently, economic growth. For economists, the most common measure of productivity is known as total factor productivity, which measures the impact on labor and capital output due to more efficient use of resources. It is often driven by the adoption of new technologies.
In the last quarter-century, total factor productivity remained flat in Japan, while rising in the United States, Germany, and neighboring South Korea. The current government is keen to change this trend: The idea is that, although the expenditure will boost the budget deficit, it could ultimately lead to faster economic growth and, consequently, faster growth of government revenue, thereby reducing the deficit.
Meanwhile, the planned expansive fiscal policy of the Japanese government has already put upward pressure on government bond yields. One challenge is that, even by the government’s most optimistic projections, the boost to productivity growth will likely come long after the government issues debt that must be serviced. In addition, there remains uncertainty as to whether the government’s program will be successful in boosting productivity growth. If not, the fiscal implications could become more challenging, which may partly explain why there is upward pressure on bond yields.
Also, despite projections of productivity acceleration, the government will still need to deal with a demographic challenge. That is, there is a growing elderly population in Japan, combined with a declining working-age population. This demographic trend is likely to add to fiscal pressures for the government.
The recent depreciation of the yen had much to do with fiscal policy. Even though bond yields have risen sharply, there remains downward pressure on the yen. So long as investors are concerned about long-term fiscal sustainability, they may seek to diversify portfolios away from Japanese bonds and toward assets denominated in other currencies. Thus, short-term intervention by central banks may have a limited or temporary impact.
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