When do higher bond yields become a problem for economies, and stocks?

Lizzy Galbraith

Hello and welcome back to Macro Bytes, Aberdeen's podcast exploring the major trends shaping the global economy, financial markets and politics. I'm Lizzy Galbraith.

Paul Diggle

And I'm Paul Diggle.

Lizzy Galbraith

And today we want to explore what's been going on in the bond markets. Over the past few months, it's become really centre stage of market conversations. So rising government bond yields across the developed economies have started to really capture investors' imaginations over the past few months. The US 10-year Treasury yield has moved back towards levels that we haven't really seen for many years now and borrowing costs have followed suit across much of the developed world. Governments are increasingly finding that financing large budget deficits is becoming more expensive, and a number of countries are now finding that they're spending more on debt interest payments than they are on their entire defence budgets. Why does any of that actually matter? One of the reasons is that government bond yields actually sit at the heart of the financial system. They influence everything from mortgage rates, corporate borrowing costs, equity valuations, government budgets themselves. And when yields start moving sharply, the effects can become something that is felt across the entire economy. So the question that investors are grappling with at the moment is whether this is simply another cyclical upswing in yields driven by changing expectations around inflation and growth, or whether we're witnessing something more akin to a profound structural shift that's been driven by persistent government deficits, large government debt piles and changing investor behaviour. So Paul and I are going to explore some of that today. But to cover off a few basics around what exactly is the bond market: put simply, a bond yield is the return that investors receive for lending money to a government. When investors buy a government bond, they're effectively lending money to that government in exchange for future payments. Bond prices and yields move in opposite directions. Or they are inversely correlated, to use another term for it. And if investors become more concerned about the outlook and sell bonds, prices fall and yields rise. And that is exactly what we have seen happening over the past few weeks. The US 10-year government bond yields, which is one you'll hear us talk a lot about today, is seen as a global financial benchmark and serves as a reference point for borrowing costs across much of the global financial system. So with that very quick introduction out of the way, Paul, can you give us a sense of how much bond yields have been increasing recently?

Paul Diggle

So you referenced, Lizzy, the US 10-year government bond, that yield at the moment is around 4.8% and six years ago in the depth of the pandemic, it was 0.5%. So over that period, it has increased substantially. Now, of course, the Fed funds rate, the policy rate of the central bank, has risen a lot over that time as well. It's itself increased by around 5 [percentage points], trough to peak, although it's come back down again since as the Fed has been cutting interest rates. And bond markets in most other major economies, the UK, parts of the Eurozone, Japan, have moved in similar kind of ways, although there's definitely some interesting idiosyncratic differences. So part of this bond market sell-off, this rise in yields, is it's a post-pandemic normalisation of interest rates out of that profound negative economic shock. But the reason why it's become particularly topical in markets of late, a big focus, is that there's been a sort of an extra leg to the sell-off since around late June, when yields on long-term bonds, so bonds that have maturity of between about 10 and 30 years, have risen in the US, the UK, Germany, France and Japan by anything from 20 basis points, 0.2%, to 70 basis points since those late-June lows. In the US and UK, we're talking about 40 basis points, 0.4%, in both cases. And that's a meaningful rise. And because it's been more concentrated at the longer end of bond curves,10-year, 20-year and 30-year bonds, it means that the so-called ‘bond curve’, the yield curve, has steepened as well. And as you said, Lizzy, these are multi-decade highs. The Japanese 30-year yield is around 4%, just below at the time of recording. The US 30-year yield is above 5%. The UK 30-year yield is approaching 6%. And those are 15- to 20-year highs in yields. And actually, you've got to go even further back in Japan's case. So a meaningful rise in bond yields, particularly at the long end, is part of a longer-term post-pandemic normalisation. There's also something obviously unique going on over the past couple of months in markets.

Lizzy Galbraith

So can you set out what some of those drivers actually are? What are the cyclical short-term drivers? What are these structural drivers? How are they all combining at this, sort of, one moment in time to have this kind of global effect that we've started to see?

Paul Diggle

Well, there are a lot of drivers. In some ways, the rise in bond yields is sort of over determined because a lot of things have been going on to cause it to happen. So maybe I'll start with those cyclical drivers. I mean, part of it, as I was saying, going back, is just the post-pandemic increase in central bank policy interest rates. And longer-term bond yields would to some extent be expected to track that rise in central bank policy rates. But since the late summer, since those late-June moves, it's really, I think, cyclically been about inflation concerns, about geopolitics and shifting expectations for the central bank. So inflation concerns and geopolitics clearly related. The Iran conflict has not gone away. We've talked about that many times on the pod. Oil price at the time of recording is close to US$100 a barrel and there's been a sense in markets that actually this energy price shock is going to be longer lived than might have initially been expected. So some of it reflects investors pricing in a slightly worse inflation picture and interest rates have to be higher to control that inflation, bond yields have to be higher therefore. And then all related to that, shifting central bank rate expectations. At his first couple of Fed policy meetings, the new chair Kevin Warsh has actually sounded a little bit more hawkish than many investors had expected. In particular, at a large set piece speech that he gave at Jackson Hole, the Fed's big annual monetary policy symposium, Chair Warsh laid out actually quite a hawkish read of the economy, of the response the central bank needed to do to the long period of inflation being above target. It's multiple years now that the Fed has missed its inflation target on the upside and Kevin Warsh sounded quite displeased with that and like he wanted to raise interest rates to react to it. So while there has been a variety of communication coming from Warsh and other Fed policy speakers, on the whole it shifted a bit more hawkish. Now that's not the main driver. I think some of these structural forces have been more important. But yeah, investors [have] had to grapple with more hawkish policy outlook and more inflation problems.

Lizzy Galbraith

Yeah, I think the geopolitical angle is one that I think is particularly interesting because as you said, it can change inflation expectations through things like commodity shocks, that's what we're seeing at the moment with Iran, but it can also affect some of the structural drivers that we're about to talk about. It can cause countries to start spending more in defence, that could affect their fiscal outlook. All of a sudden you find it very difficult to find any avenue for fiscal consolidation and your debt profile worsens because you're trying to struggle with all of these different competing sources of fiscal outlay at once. If you have elevated energy prices, you might be looking at trying to help your population with energy bill costs. At the same time as that, you might be spending more on defence from a resilience perspective. And all of this just sort of combines into one and you end up with not only sticky inflation concerns, but also sticky conflict risks and everything that comes from that as well. But on those structural points, Paul, what do we mean when we're talking about those structural risks? How are investors thinking about those?

Paul Diggle

I think it's really, it's demand and supply at the end of the day. The supply of bonds has been rising because government debt and deficits are high. And meanwhile, the demand for bonds, especially at the longer end of bond curves, has been moderating for several interesting reasons. And when you have demand weakening, supply increasing, you need prices to come down, i.e. bond yields to go up, for the market to be brought back into balance. So things that are increasing the supply of bonds, it's governments and corporate issuance. Government issuance, that's a known long-term trend that, particularly Western economies, are highly indebted: debt-to-GDP ratios are above 100% in the UK, in France, in the US. They're above 200% in Japan. And deficits are high, four or five per cent in many of those economies, six or seven percent in the US. So that means a lot of government debt issuance and investors need to be rewarded with higher yields to want to absorb that issuance to buy that government debt - to loan to those governments. And of course, governments face all sorts of pressures that means they are running these large deficits and debts, aging populations, large welfare bills, defence spending, energy support as you were talking about, Lizzy. But I think the new development on the issuance side of things and what the market's really been focusing on for the past couple of months is corporate issuance. This isn't just a story about sovereign debt supply. The US hyperscalers, the tech firms, have shifted from funding capital expenditure, the AI build out, from funding it out of cash flow, free cash flow profits, equity ultimately, to funding it out of debt issuance. Historically, those firms actually had very low debt levels. That's changed and they are now issuing a very large amount of corporate debt to the point where it's become macro significant. So the hyperscalers themselves have issued perhaps $200 billion of debt over the past year. All in, sort of all AI use cases, are issuing at least $400 billion of debt over the past year. Disproportionately at the longer end, they're issuing long-dated bonds. And that is actually 10 to 20% of US sovereign issuance, because US net issuance, net sovereign issuance is about 2 trillion a year. So we're talking now about a handful of companies involved in the AI boom issuing what amounts to 10 to 20% of what the US as a whole, the sovereign as a whole, is issuing. So I think that's the big change. And this new source of supply has to be absorbed. That supply is competing for the demand from the private sector investors. So you have to get a price adjustment, i.e. prices lower, you need yields higher. And then just as that supply picture is changing, demand for this debt has been moderating as well, particularly at the longer end of curves because many pension funds and life insurers are in surplus after yields rose post-pandemic. Defined benefit pension funds switch from being in deficit to being in surplus, so they no longer have to keep buying bonds at the long end to match their liabilities. So they're not those captive buyers. Likewise, central banks are no longer buying debt in quite the same quantity they were during the QE period. So that source of demand is going. And then because bonds are providing less of a consistent hedge to equities, because they are becoming increasingly positively correlated in a world of more supply side shocks, more inflation volatility, you're seeing simultaneous sell-offs or rallies in bonds and equities at the same time, you don't get that natural bond equity diversification that is sort of the bedrock of constructing 60-40 portfolios. And if that's the case, and actually you face more inflation uncertainty, then bond holders need more compensation for holding those bonds because if they're not going to diversify your portfolio as well then you need to get a higher yield to want to hold those bonds. Another way of saying that is that the bond term premium has increased as well. So I think a number of deep structural forces to do with the supply and the demand for bonds have pushed the yields up.

Lizzy Galbraith

So what are the means by which policymakers can try and address this change in the outlook? If these are truly structural trends, are there any actual solutions to this? Is there a way to sort of turn the clock back and to engineer solutions that would lower yields? Or is this just going to be a step change in how we need to think about bonds and bond yields going forwards?

Paul Diggle

So it's been really interesting that over the past few months you have seen policymakers, fiscal policymakers, try to intervene in the bond market. They've also actually been intervening in currency markets as well in interesting and related ways. In particular, US Treasury Secretary Scott Bessent has announced a doubling of long end Treasury buybacks. So this is where the Treasury buys back bonds that it has issued from private investors - sort of cancels them or takes them off the market and Bessent announced an increase from $2 billion per operation to $4 billion, a doubling of bond buybacks. And originally that buyback programme was introduced by the Treasury to improve liquidity conditions in the bond market, but the Treasury Secretary was sort of trying to use it as a way to intervene in markets to suppress yields or to control the sell-off in yields at the long end. The issue is, the problem is, that it's really a drop in the ocean relative to the total size of the bond market. $4 billion per buyback operation is very small in the context of, as I said, net issuance from the US government of two trillion a year and 40 trillion in total outstanding debt. And what's more, that buyback operation isn't really a net reduction in the amount of outstanding debt that the US government has issued. It's really just a swap. In the end, the Treasury will have to issue bonds somewhere else on the curve, probably shorter-term bonds to offset the cost of buying back longer-term bonds because obviously the US government isn't running a surplus. It doesn't have sort of net cash generation to do those buybacks, it will have to in the end issue debt to buy back. Debt is more just a swap from the longer end to the shorter end where, by the way, demand is stronger. And actually, we did a whole previous podcast on stablecoins. And one reason why the US government was particularly interested in pursuing stablecoins was that it would result in more demand for shorter-dated Treasuries and T-bills. So Bessent is, in a way, trying to re-profile outstanding government debt to where there is more demand for it, the area of the yield curve. And there's a lot of parallels here with the intervention that the Japanese Ministry of Finance and the US Treasury have at points done in the yen itself, where they've also sort of intervened in size that is actually quite small relative to total turnover in that market, but sort of it gives an interesting signal of where they would like to see that asset price move to. We've often said, well, you can't really turn around the price of these assets unless you change the fundamentals. But what I do think is interesting is that big policymaker intervention changes the risk reward for investors to be positioned really in one direction. If an investor was really short Treasuries, expecting yields to rise, or really short the yen, expecting the yen to appreciate, but then knew that on any given day there was some risk of intervention and an investor was basically caught out on those days because the Treasury was such a large buyer on any given day that it changes the risk reward of sort of being structurally short these markets. I think that's a really interesting way in which, even though actually it is a drop in the ocean in terms of the size of the market, it can change the risk-reward in important ways. So that's one thing they could do. Maybe it can be successful for a while but doesn't really change the fundamentals. Direct intervention. Another option is rather than the fiscal authority intervening, the central bank intervening. And that QE, quantitative easing, was that in a way, sustained bond market buying by the central bank to improve liquidity in a crisis and then ultimately to try and suppress term premia and lower yields to give the economy some support. The issue is that central banks aren't really interested in doing QE. It's not appropriate. Indeed the debate among central banks globally is whether, and by how much, interest rates should be increased. Now central banks are increasing the size of their balance sheets. They are buyers of bonds, but that's really to ensure that the size of the money supply keeps pace with the nominal size of the economy. They're not really doing active buying to lower bond yields. The third thing and what they really could do other than intervention, re-terming debt, what's called active issuance, central bank buying, is that governments could just do fiscal consolidation. So they could actually deal with the root cause of some of these structural forces we've been talking about, which is very large debt and deficits. There's just not the political will to do that at the moment.

Lizzy Galbraith

Yeah, and as you've said, the real challenge there is that we've seen these very persistent, often quite high and persistent deficits across the majority of developed economies and actually even some of the countries that we would traditionally associate with running a surplus and having very low debt and deficit levels like Germany, they are now finding reasons to change that policy and to start borrowing more money so they can spend on defence, on infrastructure. So even those countries that we would traditionally think of as being very low debt economies - you're now starting to see a shift as some of those demands that we mentioned earlier are starting to build and they're starting to find that there's just there's too many competing priorities for the status quo and that the flip side of that is also true for the countries that already do have very high debt and deficit levels. It's just very challenging to find things to cut in the current global environment that we're facing at the moment. You can see that in the US where the economy is actually pretty strong, growth is pretty good, but you're still getting these investor concerns because the US runs quite a persistently high deficit and very, very rarely actually runs a surplus. And that's governments of all parties have really struggled to change the trajectory there. The UK is another one where we often talk about the UK being at the forefront of moves in the bond market and certainly one of the countries where you would describe, I think, those concerns about fiscal trajectory being more acute than some others. So Paul, why exactly do we talk about the UK so much when we talk about bond yields?

Paul Diggle

It's been at the sharp end of many of these bond market moves. In market parlance, it's been a high-beta bond market. The selloffs have generally been larger in the UK than globally. I mean, some of the reasons for that, as I said, the UK is a fairly high government debt, high deficit economy, but doesn't stand out relative to peers as being a particularly bad case of fiscal indiscipline. I do think the design of the fiscal rules and the focus on headroom and the drama of the set piece budgets can inject a bit of uncertainty into the bond market because it leads to a lot of speculation of how much headroom is there going to be, what are those measures going to be, that particular fiscal institutional setup can at some points be unhelpful. The UK does have growth challenges, of course, past couple of quarters have been better, but for a lot of the post-financial crisis period and the post-Brexit period in particular, the UK has had an unhelpfully low trend growth rate, which doesn't help when you're trying to grow your way out of debt. And because one way to lower debt-to-GDP ratios, of course, isn't necessarily to lower the debt, it's to raise the GDP, the denominator of that ratio. UK has perhaps a more volatile inflation generating process, certainly seems to have a problem with high inflation expectations that could be to do with the negative supply shock of leaving the EU and having a less flexible labour market. And I think the most important one, though, is that the structure of the bond market - who is buying UK gilts -has changed somewhat, such that that market is relying on the kindness of strangers, as it were. Unlike the US, gilts aren't the global safe asset. And we've done podcasts where we've talked about whether the US was sort of losing that status. And that's a big sort of question for investors to be thinking about. But for now, at least that gives the US the so-called ‘exorbitant privilege’ of people wanting to buy Treasuries in a crisis, sort of like you flee into that asset and that provides a degree of support. UK doesn't have that. And unlike, say, Japan, where there is even higher debt-to-GDP ratio, the UK doesn't have the same pool of strong domestic demand, at least not after 2022 and the Truss episode, the LDI deleveraging that followed that, the increase in yields, meaning that many pension funds were in surplus again, changing LDI regulation. So there's no longer that captive source of buyers at the long end. I mean, on the other hand, those changes also mean that LDI is less a source of crisis risk. So yeah, that's a good development, but it does also mean that DB pension schemes aren't such large structural buyers of gilts. So yeah, I think a number of factors combining to mean that the UK is a sort of high beta bond market.

Lizzy Galbraith

I think as you said, the UK really is a country where quite a few of the issues that we've been talking about really do converge into one. It is a country where it's found itself in a position where there's a very persistent deficit level. It's found it really challenging to be able to reduce the deficits consistently at least. You've also had successive challenges that the UK economy has really struggled to recover from, starting, as you said, with Brexit, but obviously we're still in sort of the post-pandemic recovery phase. You've then had successive energy shocks. You're building on top of that the needs to spend more on defence as a NATO member. And we're constantly having this debate around whether or not the UK is able to meet the 3% NATO defence spending target by 2030 or not. And then all the conventional challenges that you see across the developed economies now, like ageing population, how much of your fiscal space should be taken up by things like healthcare, pensions et cetera, particularly when, as Chancellor John Healey points out, you're spending £1 in every £10 of government revenue on debt interest. So it is already something that has quite a meaningful impact on the UK fiscal space. And the structure of our budgets does, as you say, lend some drama to the process. We have to deal with that every year. And part of that is driven, I think, by, as you say, the act of having a number that you can ascribe your fiscal headroom to really does make it a sort of pass-fail question for the government and therefore for markets. It makes it very unambiguous, I think, in a way that is not necessarily that helpful on a sort of day-to-day basis, particularly as we are in now an era where fiscal headroom is really quite low by historic standards. The government is sort of scraping by every year. That is something that I think does contribute to a level of persistent focus on the health of UK public finances that makes it quite challenging for governments to sort of turn down the heat when it comes to scrutiny by markets of their fiscal strategy. Certainly not alone in that.

Paul Diggle

Well, that's an interesting irony, isn't it, Lizzy, that the point of the fiscal rules that then give rise to the headroom calculation and the point of the OBR, an independent budget authority that crunches those numbers, is to raise fiscal credibility. And in many ways they do that. The Truss experience shows that when you sideline the OBR, that's even worse from a bond market perspective. But the sort of irony of that transparency is that then when you are very close to breaching some of those rules, it's very obvious to everyone in a way that perhaps if you sort of were a little bit vaguer about the numbers, you wouldn't be. I mean, maybe the original scene here actually is just running such small headroom in the first place, being so close to breaching the rule at any given time. And if you had a much larger headroom buffer, then a reduction in headroom wouldn't be as painful because you wouldn't have to change course, because you still have plenty of headroom one way or the other. It's really actually running right up against those rules, not the existence of the rules themselves that's maybe the actual issue here.

Lizzy Galbraith

Yeah, and of course the EU has its own sort of version of this with its debt rules, which all member states are of course supposed to adhere to. Not all of them do, but there is a process by which they are supposed to be reducing debts and deficits that are deemed to be beyond the expected level. And maybe the reason why we don't have the same level of scrutiny on a conventional basis, at least when it comes to some of those countries that are in excessive deficit procedures versus the UK's fiscal headroom is that the UK's fiscal headroom is measured in billions. It is a single number that you can really kind of dig into and measure that can often fluctuate on a weekly basis depending on what's been going on in markets. Whereas the EU do measure theirs in percentage terms. And I think it does just make it feel a little bit less dramatic, less prone to these kind of fluctuations that can immediately erode it depending on if you had a bad week or not. And we did have that in the run up to the 2024 and 2025 budget, there was this constant rolling speculation of whether or not the government had entirely eroded its headroom or not, whether it was going to have to start from a basis of spending money not on policy, not on new initiatives, certainly not on anything that you could deem to be growth enhancing, but simply on building back fiscal headroom to try and restore market confidence. So I think you're right, there is an extent to which yes, it was a tool to instil confidence in the government's fiscal policy. The absence of it clearly isn't an option, but it does sometimes, I think, overplay the sort of the day-to-day fluctuations in fiscal policy in the UK relative to sort of similarly indebted economies like we have in the Eurozone. So, with all of that being said and done, Paul, what does this actually mean for equity markets? Is there a point at which you see rising bond yields start to have an effect on markets more generally, or is this something that we feel is going to be contained into a single asset class for now?

Paul Diggle

Crucial investor question. Obviously, bond market matters in and of itself, it's enormous, but it's spillovers to the equity market are also a big focus. And first principles, I mean, higher bond yields raise the discount rate you apply to future earnings from companies, the earnings of your equity holding. So that's bad because those future earnings would be worth less today if the interest rate is higher today. And that's particularly problematic for so-called growth companies, including tech companies, where a lot of their earnings are expected to be in the future and their sort of costs, their investment costs, are in the present. And borrowing costs can also, obviously in time, they affect the real economy as well. I mean, the purpose of a central bank raising interest rates is ultimately to raise the cost of capital. That means weaker housing market activity, investment spending, consumption, you know, would increase desired savings relative to desired spending. So it sort of crimps the economy as well. That's the purpose of controlling interest rates in many ways. But it's not as simple as that, because even as interest rates have risen dramatically in the post-COVID period, of course, equity markets have done extremely well over that period. So it's clearly not a one for one movement. And I think what really matters is why bond yields are moving. how much they're moving and how fast, rather than that they're going up or down or any given level being some sort of threshold beyond which it suddenly becomes a problem for the equity markets and for the economy. So let's think about the why. There can be good or bad reasons for bond yields to rise. If growth is better, it's a good thing. In fact, you would generally say it's a sign of health that interest rates are rising. And don't forget that during the period of very low and indeed negative interest rates, that was generally seen as a sign of dysfunction in the economy. So it should be sort of celebrated in a way that yields look more normal, interest rates look normal. Today, there are probably both good and bad reasons as we went through. That increase in corporate issuance in particular from the tech firms that is funding real economy investment, a real world build out of that infrastructure that is generating economic growth. And if in time, the AI boom also raises productivity and the supply potential of the economy, then those are all very good reasons to be increasing issuance. And that should actually, by no means be a headwind. On the other hand, some of these reasons are bad reasons. They're to do with, as we said, more inflation, more inflation volatility, worries about government debt sustainability. So there's sort of both sides of the ledger seem to be happening. Then if we think about how much they've risen and how fast, as we said, maybe 40 basis points on US and UK 10-year, 30-year debt over the past six weeks or so. That is a meaningful move, but it's still only around a one-standard-deviation move in bond yields over that time period. And if you look back at the relationship between the bond market and equity market, it generally seems to be that you need greater than one standard deviation moves, indeed perhaps two standard deviation moves in bond yields for that then to become a sustained headwind to the equity market. So put another way, the move is not yet big enough or violent enough. And you've seen measures like the MOVE bond-market volatility index still be quite contained. So they're not yet big enough to present a real threat to the equity market. And that could change, if the bond market sell-off were to become larger still, perhaps if we were to exceed 5 or 5.2% on the US 10-year in quite short order, then I think you would start to see more of a sustained headwind to the equity market. But yeah, the framework should be not that any given level of bond yields is problematic, but the why, the speed, the size of the move, that's what really matters.

Lizzy Galbraith

I think on that note, we will end it there. So thank you very much everyone for listening. Please remember to like and subscribe and we will be back in a couple of weeks with another episode. Thanks for listening.

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