Why global bond markets are convulsing

ALMOST everywhere, government bond yields are rising fast. Those on 10-year American Treasury bonds are almost 5 per cent. German bunds now offer 2.6 per cent, up from close to 2 per cent in December. Japanese bond yields are climbing. Things are particularly extreme in Britain, where gilt yields recently reached almost 5 per cent, their highest since 2008. Rising yields are bad news for governments, which must pay more to service debts. They are also painful for all sorts of other borrowers, including many mortgage-holders, whose bills ultimately depend on governments’ borrowing costs.

What is going on? Central bankers across the rich world have cut rates – yet the real economy is seeing little or no relief. The borrowing costs facing businesses and households have barely budged. In the euro area, the interest rate on new business loans has fallen by less than a percentage point. A British consumer looking to borrow £10,000 (S$16,657) pays an average rate of 6.75 per cent, just short of a recent peak. And in America, the rate on a 30-year fixed-rate mortgage is close to 7 per cent, having risen by a percentage point over the past few months. The situation marks a profound change from before and during the Covid-19 pandemic, when bond yields were heading to all-time lows.

Inflation is part of the explanation. In a world where consumer prices are rising quickly, investors demand higher bond yields both because they expect central banks’ policy rates to stay higher for longer, and to compensate for the anticipated erosion of the principal’s purchasing power. Recent data hints that inflation will fall more slowly than once hoped. Across the G10, nominal wages are still increasing at 4.5 per cent a year, which is probably enough to push inflation above central banks’ targets given weak productivity growth. In the euro area, there are signs that wage growth is actually heating up; in America, a blowout jobs report, published on Jan 10, suggests the economy is far from slowing. Survey-based measures of inflation expectations, in some countries, are rising. So are inflation readings. Average inflation in the G7 rose from 2.2 per cent in the year to September to 2.6 per cent in the year to November.

But market pricing suggests something else is also at play. Worries about price rises are not – at least outside Japan – showing up in rising expectations as measured by inflation derivatives (financial contracts with payoffs determined by price readings). In America, Britain and the euro area, such inflation expectations have fallen in recent weeks. Investors seem to believe the economy has more inflationary pressure than previously supposed, but also that central banks, in the most likely scenario, will be able and willing to contain it with more hawkish monetary policy.

Instead, the big change concerns greater uncertainty in investors’ expectations. This could be pushing up the “term premium” – the extra yield investors charge on long-term government bonds, over and above that attributable to the changes in the central bank’s policy rate that are already expected. The term premium compensates bondholders for the risk that bond prices fall sharply; say, if unexpected inflation forces central banks to aggressively raise rates. Sure enough, increases in the premium on 10-year Treasury yields account for nearly all of the rise in these yields since early December.

It is easy to see why uncertainty has spread. Will Donald Trump deport millions of people? Nobody knows. But if he succeeds, inflation could jump as employers lose workers. The story is similar for tariffs, which would also increase prices. At the same time, potential Chinese countermeasures in a trade war, such as a devaluation of the yuan, could prompt a global deflationary shock.

Investors are also unsure about economic growth. The dominant narrative veers from one extreme to the other. Some investors worry about the damaging effects of deglobalisation and a slowing Chinese economy. But there are optimists, too, including those who believe that Trump’s mooted economic-policy reforms, including slashing red tape and cutting taxes on everything from tips to social security, will spur growth. Maybe an AI-powered productivity surge is around the corner. The effect of all these contradictory scenarios is to raise the term premium on government bonds even more.

Fiscal policy is not helping matters. This year, G7 governments are expected to run an average budget deficit of 6 per cent of gross domestic product – unusually high considering that unemployment is low and economies are growing well enough. Funding these deficits means issuing fresh bonds. America is expected to issue about US$2 trillion worth (equivalent to 7 per cent of GDP) this year, after accounting for redemptions. Eurozone governments will collectively issue perhaps 500 billion euros (or about 3 per cent of GDP).

Such hefty supply puts pressure on bond prices to fall – forcing up yields, which move inversely. Plenty in the market fear that America’s fiscal trajectory, long unsustainable, will soon be brutally exposed, especially if Trump’s tax cuts materialise. A revolt by bondholders could send yields yet higher. Research by Goldman Sachs suggests that each percentage-point increase in the deficit-to-GDP ratio raises long-term yields by about 20 basis points. In America, the supply of long-term Treasuries may grow by even more than the deficit would suggest. Scott Bessent, Trump’s pick for Treasury Secretary, has previously proposed borrowing less via short-term notes and more via long-maturity bonds.

Central banks are making life even more difficult for spendthrift governments. To deal with high inflation in 2021-23 they launched quantitative tightening (QT), reducing the size of their balance sheets by offloading government bonds (and other securities). With central banks no longer buying bonds, and in many cases actively selling them, private investors have to absorb even more. We estimate that this year, because of QT, the average G7 country will effectively have to sell double the volume of bonds it officially plans. The European Central Bank’s QT is likely to more than offset efforts by national governments to cut issuance by reducing budget deficits.

What happens next is, like everything now, supremely uncertain. In some countries, especially Britain, it would be no surprise if yields fell a little. In part, because QT is set to slow, the country will soon be selling fewer bonds to the market. Meanwhile, across the rich world, worries about resurgent inflation could turn out to be misplaced. But the fundamental forces driving up yields are unlikely to disappear. Expansionary fiscal policy is in vogue, geopolitical tensions continue to rise, and trade tensions could intensify.

Bear in mind that, although the term premium has risen, it is nowhere near the levels of the past. After high inflation and rapidly rising interest rates during the 1970s and 1980s, which savaged the real value of bond portfolios, investors shunned government debt. Well into the 2000s, the term premium was measured in full percentage points, not the tenths of today. Imagine that investors are wrong about the odds of central banks cutting interest rates this year, and policymakers are instead forced to start raising them again. Investors would have ample reason to shun sovereign bonds. If they do, there is plenty of room for yields to rise even further.

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