Will the bond vigilantes return?

Paul Diggle

Hello, welcome to Macro Bytes the economics and politics podcast from abrdn. My name is Paul Diggle

Luke Bartholomew

And I'm Luke Bartholomew.

Paul Diggle

We need to talk about debt. Global government debt has now risen above $100 trillion, close to 100% of global GDP. Depending on how you measure it. US government debt is well above 100% of GDP and the deficit is close to 7% - extremely large for this point in the economic cycle, where the economy is at full employment and inflation is still something of a concern. And US debt servicing costs are around 3% of GDP, not very far below the US’s total defence spending, say. And depending on quite what he does, a Trump presidency could increase the US deficit still further, and a lot of other economies may have to increase spending to offset some of the impact of Trump's international policies, not to mention meet the rising costs of aging populations and public infrastructure needs.

And partly reflecting all this, government bond yields have been rising. US ten-year Treasury yields are about 75 basis points higher since the start of the Fed's easing cycle back in September. Ten-year gilt yields in the UK are about 50 basis points higher over that period, which of course included the fiscal expansion announced in the budget. So the term ‘bond vigilante’ was coined some 40 years ago now by Ed Yardeni, a long time Wall Street economist, to get at the idea that the bond market can be an important disciplining device for fiscally profligate politicians. By selling bonds, increasing government borrowing costs, bond markets can rein in government spending when they are worried about fiscal sustainability. For the longest time, this spectre of the bond vigilante was more frightening than the reality. But I think something very important is now changing under the surface.  The term premia - the component of US bond yields that is left once you remove market expectations for the policy interest rate - so the part of bond yields which is really just telling you about how willing the market is to lend to the government, that has risen from being deeply negative in the aftermath of the financial crisis, i.e. markets were very willing to lend to the US government especially, to being essentially zero today and there could be plenty of scope for it to rise further if markets become worried about fiscal sustainability. So, we're asking on the podcast today, will the bond vigilantes return?

Luke Bartholomew

So, as you say Paul the job, as it were, of the bond vigilantes is to monitor and police fiscal sustainability. But then that raises the question of what we might mean by fiscal sustainability. And that turns out to be a far from straightforward question. I mean, at the semantic level it might seem pretty clear, in the sense it's about the ability of the government to service its obligations. But already then we're into the difficult question of what we might mean by obligations. Is it just the outstanding government debt out in the marketplace, or is it other obligations that the government has to the public, both explicitly through benefits, welfare payments, and also implicitly in other commitments it has to the public realm? And also what's the real terms value of these obligations in terms of their, value to be able to be turned into consumption power in the future? And sometimes the sustainability of one kind of obligation might turn on de prioritizing other obligations. So perhaps the outstanding market debt is only sustainable if the government, as it were, defaults on certain social obligations, or it defaults by reducing the real value of what they are repaying through higher inflation.

 So already we see that the question of sustainability is really a political economy question. It's not just a straight economics one. It's bound up with social and political values and choices. But let's focus for now on the more narrow definition of sustainability that relates specifically to government debt issued in the bond market - treasuries in the US, gilts in the UK, bunds in Germany, etc. and this is perhaps where direct economic questions are a bit more immediately pressing.

And I think the first thing to say about sustainability in that sense is it's not about some fixed limit to the amount of debt that a country is able to issue. I mean, in the post financial crisis period, there was this now rather infamous consensus for a couple of years that if a country's debt to GDP ratio got above a certain fixed limit, generally thought of as around 90% of debt to GDP, this would then tip the country into a position of fiscal unsustainability - economic growth rates then collapsed in response to this higher debt. Now that finding and that entire way of thinking about debt is widely discredited. So I think a better place to start is less with the level of debt and more about the trajectory of the fiscal position. And then when you start thinking in those terms, I think what becomes clear is that the very minimum condition of debt sustainability is that the debt to GDP is not on a path to increase without bounds. You know, pretty trivially, if the debt ratio is set to increase infinitely at some point we will run out of GDP resources to service the debt. So that must be unsustainable. But to be fair, it isn' t often that those kind of limit cases are the ones that we’re wrestling with when we think about fiscal sustainability. In many ways, it can be more about the robustness of the current path of debt to GDP to certain shocks. So, for example, a debt level might be quote unquote, ‘sustainable’ at one interest rate but not sustainable and another interest rate. Or to link it back to the political economy point, if debt servicing costs reach a certain level or political priorities shift, then the debt level might become unsustainable as governments are no longer willing to service their obligations, even if they are physically able to do so. So again, the point is that debt sustainability turns on complex economic and political interactions, which are subject to shocks, and these can easily tip us from one kind of equilibrium to another.

Paul Diggle

Yeah, and any workhorse economic model for doing debt sustainability analysis, thinking about the trajectory of government debt, relies on two fundamental variables R and G in the lingo. So R is the real interest rate the government pays on its debt and G is the growth rate of the economy. And for a balanced primary deficit, meaning that government spending equals the tax take net of interest service costs and an R minus G of greater than zero (that is an interest rate that is above the growth rate) causes the debt stock to increase over time. Governments would have to run a primary surplus, they'd have to spend less net of interest than they take in in taxes to stabilise debt. By contrast, an R minus G of less than zero (that is a growth rate above the interest rate) means debt falls. Or put another way, the government can run a primary deficit while still achieving fiscal sustainability. But the complexifying factor here is that R and G are not really independent of each other, and nor are they exogenous to the level of debt itself. There are complicated interactions. So for example, pushing up on debt could push up on interest rates for reasons we're going to get into investors may demand higher term premia on government borrowing. The bigger your debt level the more expensive it can be to service it. At the same time pushing up on interest rates could push up on debt and R can rise for a variety of reasons to do with shocks hitting the economy - inflation shocks for example. A higher interest rate could also push down on growth, perhaps because the public sector has less latitude to do fiscal stimulus to support growth. More of its resources are absorbed in servicing the debt load, and at the same time, higher growth could drive higher interest rates because interest rates are in part a reflection of trend growth expectations. Then finally, pushing up on debt could plausibly push up on growth rates via investment and other forms of fiscal stimulus.

Luke Bartholomew

And so then, to illustrate the importance of a changing R interest rate environment, not just on fiscal sustainability, but also just how the economy operates as well, I think it's useful to be concrete and to compare the post-financial crisis period with today. And of course, following the financial crisis, interest rates across much of the developed world fell to zero. Central banks are trying to stimulate demand in a demand deficient economy, which was suffering from high unemployment. And that's why interest rates were low in one sense. But in a somewhat deeper sense as well the economy was in what we call a liquidity trap, where the demand for liquidity, which includes certain safe sovereign bonds, was effectively near infinite. So increasing debt in that environment didn't push up on interest rates because it wasn't satiating the demand for that debt at the margin. So there was no need for prices to adjust for prices to fall or interest rates to increase. And so a crucial policy recommendation that flows from this kind of situation is that fiscal easing financed by higher government debt issuance is appropriate. There are unemployed or underutilised resources that can be put to work by easier fiscal policy, and interest rates will stay low through that period of easing, the government is able to issue a large quantity of debt and  not to push up on interest rates. And in fact, actually, fiscal consolidation in that environment can be self-defeating in its own terms as it ends up hurting growth – G. You know, so much so that G is lower - and that's what makes the debt less sustainable. But now, of course, we are in an environment where interest rates are much higher and debt servicing costs themselves are becoming more problematic. And importantly, even with interest rates having come down a little bit from their most recent peaks, debt servicing costs will actually keep increasing. That's because the government is constantly having to refinance debt at a higher rate. So bonds that were issued 10,15 years ago in that zero interest rate environment I was just describing, are now maturing and need to be refinanced at the higher interest rates that prevail today. And moreover, not only are we in a higher interest rate environment, but we're also an economy broadly at full employment in the US, the UK, and so fiscal easing doesn't have the same stimulating effect that it would have had back after the financial crisis. There aren't underutilised resources waiting to be put to work. Instead, the government is, in a sense, in competition with the private sector for economic resources. And so, to the extent to which the state utilises those resources, the private sector has to commensurately shrink to free up those resources. This is, you know, in the in the lingo, in the jargon ‘crowding out’. And we talked about this quite a lot in the context of the UK's recent budget in a podcast a few weeks ago. And the key point that we were drawing out there is that the OBR’s forecasts after the budget didn't show a material increase in medium term growth. In fact, they were actually a little bit lower precisely because this mechanism of crowding out was at work. And part of the way in which that occurs is through the process of interest rates staying higher than they otherwise would have done.

Paul Diggle

So, whereas questions of debt sustainability didn't particularly bite during that period, that zero interest rate period post financial crisis, at least in the US, maybe in the UK, of course, somewhere where debt sustainability was a very key issue was in the eurozone, amidst the European sovereign debt crisis from around 2009 to let's say 2012, when Mario Draghi did his ‘whatever it takes’ speech. Greek, Portuguese, Italian, Cypriot bond yields were all well into double digit rates at a time when the ECB policy rate itself was essentially zero. And debt sustainability mattered, markets were worried about government debt loads, not just because of the size of said debts and the potential inability of the tax base to credibly service and in time hypothetically repay the debt load, but also, I think, crucially because of the structure of the eurozone itself, the ECB was not a credible lender of last resort to back a fragmented national-level fiscal system and layering on top of that was an incomplete capital markets union, which meant that there was a large home bias in bank holdings of sovereign debt and an incomplete banking union, which meant that the backstops, the bailout mechanisms to banks, were for a period of time national rather than supranational in character. And all that, that architecture, that incomplete architecture, gave rise to this infamous doom loop, whereby private banks were stuffed full of government debt, the solvency of which was linked to national economic prospects, and when those started to deteriorate there would be rising losses on government debt, which meant that commercial banks were making losses, which meant that national governments were on the hook for said losses. And then so there was this kind of reinforcing downward feedback loop, this doom loop, which really meant the debt sustainability bit hard.

Luke Bartholomew

And similarly, there was a debt sustainability crisis in the UK following the Truss / Kwarteng mini budget episode in September 2022, which again had some of these feedback loop dynamics at play, albeit in a slightly different way. So, as you might remember, the government back then proposed a package of tax cuts, and energy subsidies, and indeed with a promise that this was just the start and that more was to come. And it did this at a point when inflation was still high. And so the job of monetary policy was very much to lean against the wind, to be restrictive, to cool inflation and to increase interest rates as necessary in response to inflationary pressure. And so this big fiscal easing that the government announced led to, in the first instance, an increase in bond yields, partly in anticipation of that need for tighter policy. And then this was layered on top of, some financial market plumbing feedback dynamics that started to bite really hard, whereby increasing bond yields, which is to say falling price in gilts, caused certain institutions to sell their gilts because of the liability-driven investment strategies that they were involved in and so they were selling into a falling market which was then begetting even greater price falls, which in turn caused the need for more sales. And you can see how this feedback loop can then become really quite nasty. And in fact, where this really played out was at the longer end of the gilts curve with yields there rising over 100 basis points in a short order, sterling falling sharply as well. And I don't think it would be an exaggeration to call this a genuine market crisis. And so it was only really the intervention of the Bank of England as a credible lender of last resort to buy up gilts, that stopped this feedback loop from continuing to feed on itself. And I guess one other crucial point that emerges from this story is that, you know, there are hard limits to the amount of sovereign borrowing that is available at certain times. This will depend on the state of the economy and certain market technical factors. But those binding limits do exist, and those are quite separate to the government's own rules that it might have around how much borrowing it allows itself between, you know, current day to day spending and investment spending. All of this at some level, can seem a little bit political and parochial when you are faced with at times, the binding constraint of the market. So I think, yeah, it is just important to remember that sometimes the reason fiscal policy is the way it is, is not just because the fiscal rules are the way that they are, but because the market itself imposes limits.

Paul Diggle

Yeah. And another interesting takeaway, I think, that emerges from those historical lessons is that debt sustainability becomes particularly problematic, both when investors doubt government debt servicing ability, where they worry about having to absorb large issuance, but also where there are financial plumbing feedback dynamics that can exaggerate these large sell offs. Both those two examples, European sovereign debt crisis, the UK Truss / Kwarteng mini budget involved those sorts of feedback loops, and the complexity of the financial system means that these kind of feedback loops can be lying around, waiting to be exposed by sharp market moves.

But look, on the other hand, I think there's this really fascinating example of Japan where a 260% debt to GDP ratio seemingly hasn't mattered for bond investors, there has been no fiscal crisis, despite the debt load that I think going back 20, 30 years would have been almost unimaginable. And I think that is to do with questions of market structure as well, because Japanese debt ownership is very different and somewhat unique than many of the Western DM economies. Japanese government debt is disproportionately held by domestic institutions, including the big pension and life insurers, but also the Bank of Japan itself.There’s an incredible degree of home bias in holding Japanese sovereign paper and Japan's consolidated net debt, what it owes internationally rather than to itself, is actually on a par with the US, less than half the headline debt to GDP level, and that ownership structure, I think imparts a certain stability that prevents the sort of fire sales and feedback loops that we've been talking about elsewhere. But of course, while there's been no fiscal crisis in Japan, there has been the ‘lost decades’, a long period of subdued nominal growth in the aftermath of the bursting of the stock market and real estate bubble in the late 1990s, which is tied up with the size of the debt load and the restrictions that places on activist monetary and fiscal policies, strictures that Abenomics and periods of Japanese policy have tried to escape, but only ever half successfully. And I think, looking ahead, a really important question for financial markets is, are those lessons telling us something about the future of say the Chinese economy, where debt loads are pretty large, at least for an EM when typically debt is lower than in the older, richer developed market economies. Whether a form of Japanification, low growth, low inflation, is what lies in store for China, or indeed, whether a full-blown fiscal crisis is what lies in store.

Luke Bartholomew

So having completed that, geographical and historical tour there which I think has given is a very good framework, both conceptually and empirically, for thinking about these questions around debt sustainability, we should turn back to the US. And I think, you know, the crucial point to make around the US that distinguishes it from many of these other cases that we've been talking about is, of course, that the US does issue the reserve currency. That is to say, the dollar is widely used for global trade investment. That's a store of value. And that means that there is this ongoing large source of demand for US government paper that's quite above and beyond, you know, other economic factors around growth, inflation policy, interest rates, even sustainability considerations per se, as well. There is just this ongoing desire to be able to own US government debt. And what that effectively means is that the interest rate that the US government pays on its debt is lower than it otherwise would have been, and this higher demand pushes up on prices and so down on interest rates. The US government faces these lower government borrowing costs and that's what we mean often by the ‘exorbitant privilege’ that the US government has.

And I suppose the other aspect of that exorbitant privilege that's interesting to us is not just that interest rates on average are lower, but the US can sort of avoid some of those nasty feedback dynamics we were describing taking effect in other markets. But because the US, as the reserve currency issuer is also the issuer of the global safe asset. So in terms of crises, when things are going wrong, even if that crisis is in the US, there is often a rush to own US government debt. And so again, pushing up on prices, down on interest rates. And so in those crisis moments, the US government enjoys lower interest rates rather than higher ones.

Paul Diggle

And I guess, a key question to the future of US sustainability then would be, well, could the US lose that exorbitant privilege, could it lose its reserve currency status? And I think the answer is probably no, with some important caveats. I mean, having that reserve currency status is deeply interlinked with the depth and liquidity of the US capital markets, which far outstrips those of any other competitor economy or currency or asset. So, for example, 60% of global FX reserves are in dollars, US equities are 60% of global equity indices. Half of all cross-border bank loans are in dollars. A similar proportion of over-the-counter foreign exchange transactions are in dollars. These completely outstrip the US's size in the global economy but they are powerful, self-reinforcing mechanisms - network effects which challenger currencies, whether that be the Chinese renminbi or the euro or, you know, entirely new currencies like crypto or BRIC currencies, just cannot compete with. And then this reserve currency status, this safe asset status also relies on things like the US rule of law, institutional stability, the US Treasury committing to strong dollar policy that generally avoids intervention. Of course, some of those features could be in doubt in the incoming Trump administration. We've done a whole podcast about possible dollar policy under the Trump administration. That said, the thing, the new thing we've learned since we did that episode was the appointment of, the nomination of, Scott Bessent as US Treasury Secretary, a pretty mainstream Wall Street hedge fund figure who sounded pretty committed to the dollar as the global reserve currency. And that has somewhat reassured markets. But look, other stuff is changing, too. The geopolitical rise of China, the US's use of sanctions on Russia done through the dollar payment system. These are all incentives for those economies to gradually diversify away from the dollar. And I think it's notable, too, that China is, of course, the second largest international holder of US debt. Some people float that as a supposed kind of source of Chinese leverage over the Treasury market, that there could be this kind of fire sale, dumping of treasuries, which I think I'm pretty dubious of. Those arguments involve a lot of sort of shooting oneself in the foot. So for now, I don't think there are real alternatives to the dollar as the global safe asset that really helps US debt sustainability. But, you know, watch this space. I think things are changing over the longer run.

Luke Bartholomew

But look, I mean, even if the US doesn't lose its reserve currency status, its exorbitant privilege that comes from that, there are still, I think, good reasons for thinking that US government borrowing costs should systematically increase over the medium term. The term premia, as it were, should increase. And those are not just to do with debt-based reasons. And we've talked before on the podcast about how we think we might be moving to a world which has systematically more negative supply shocks, shocks that push up on inflation and down on growth at the same time, that's the changing patterns of globalisation, geopolitical shocks, supply chains having to be changed quite significantly, climate change shocks, as well. And this higher inflation volatility leads to greater uncertainty around obviously the path for inflation, but also the path for interest rates, and also tends to mean that bonds are a less good diversifier for equities because you're getting periods of high inflation at the same time as you're getting periods of weak growth. So, all of this should mean that, you know, on balance, investors need slightly higher compensation to be prepared to hold bonds in the future, which is just another way of saying that the price should be a little bit lower, or the term premia needs to be higher. And then just looking at the debt path, again you don't have to be worried about full on sustainability concerns to think that a big deficit expansion under the Trump presidency should be associated with some increase in the term premia. Ultimately, to think about this very simply, there is going to be a large increase in supply of government debt coming at a time outside of a liquidity trap, and so in which, investors do need to be compensated to be prepared to hold this extra debt. And so the price needs to fall, the interest rate needs to increase a little bit. So we do think there are good reasons for thinking that term premia should increase over the medium term, even if we are not staring down the barrel of a full on fiscal crisis.

Paul Diggle

Yeah. So the 30 odd trillion dollar question is, is an outright fiscal crisis possible in the US or elsewhere? And I think from what we've explored here the answer is probably no. I mean, we are less worried than we would otherwise be about things like government shutdowns, budget standoffs, debt ceiling standoffs, in light of unified Republican control of Congress. So those sort of technical defaults, administrative defaults, as it were, are less likely than they could have otherwise been. And, you know, we're not really worried about Trump's occasional threats on the campaign trail of sort of selective targeted defaults on certain foreign holders of U.S. treasuries as a sort of souped up version of using tariffs as a negotiating tool. Then you'd use the debt stock itself as a negotiating tool that I think is extremely unlikely. But I think we are, as you say Luke, more worried about an ongoing potential increase in the term premia as some of the forces we've been talking about play out. So the US ten-year term premia, that is to say, the part of the bond yield, extrapolating away from expectations of the policy interest rate, the part that really boils down investors willingness to lend to the government was about -1% in the US at its lows, post financial crisis. Borrowers were paying in a way to lend to the government's ex of policy rate expectations. And in places like Germany, they were just outright paying to lend to the government because the bund yield itself was negative. And that term premia in the US has now risen back to about zero. But there's substantial headroom for it to increase further. As recently as the early 2000s, ten-year Treasury term premia stood above 2%. So I think it's perfectly plausible that that scale of move in term premia could play out if the sort of debt concerns we've been talking about continue to build in markets.

Luke Bartholomew

Well, as you say Paul, watch this space. But I think that is all we have time for this week. As ever, please do let me remind you all to like and subscribe wherever you get your podcasts. And then all that remains is to thank you for listening. So thanks very much and speak again soon.

 

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