A sense of foreboding continues to haunt global bond markets. Having dropped back at the start of last week, government bond yields then rose again in the middle of the week and the bond sell-off intensified on Thursday and Friday. It is important to get matters into perspective: despite recent moves, yields everywhere remain low by historic standards. But the events of the past few weeks have brought some difficult questions into focus. Chief among them is how central banks might respond should they be faced with a large and sustained rise in government bond yields in the future.
The short answer is that it is likely to depend on what’s behind any increase in yields.
Most of the attention has inevitably focussed on what’s been happening in the US. Until recently, the rise in 10-year US Treasury yields from the lows reached last August had been driven by an increase in inflation compensation. Given that inflation expectations were lodged below the Fed’s inflation target, their subsequent rise was greeted as a sign of faith in the ability of policymakers to drive inflation back to target. And since inflation compensation is still lower than Fed officials would like, a further rise in yields driven by a rise in inflation expectations is unlikely to provoke much of a response.
However, the increase in yields over the past couple of weeks has been driven by a rise in real yields. This poses an entirely different challenge for the Fed.
As our Chief US Economist, Paul Ashworth, argued in a piece last week, the response to a rise in real yields will be determined by several factors. One is the scale of the move. Another is the economic and market context: policymakers are much less likely to respond if they believe that the rise in real yields is justified by an improving economic outlook and does not jeopardise financial stability.
Finally, it matters whether the rise in real yields comes at short or the long end of the curve. The former might indicate that the markets do not believe the Fed’s commitment to keeping its policy rate at near-zero until it has achieved a “broad and inclusive” recovery. The latter could indicate that the markets believe that the Fed will keep support in place in the near-term, but that it will then fall behind the curve and let inflation spiral out of control further ahead.
This will have a significant bearing on any policy response. If yields rise at the short end of the curve, the Fed could follow the example of the Reserve Bank of Australia and adopt an explicit target for short-dated yields (the RBA targets the three-year part of the curve). If they rise at the long end of the curve, it could skew its asset purchases towards securities with a maturity of 10 or more years.
However, the key message from the various speeches by Fed officials last week, including Jerome Powell, is that they are not overly concerned by recent moves in bond markets. Instead, they appear to be taking comfort from the fact that the short end of the curve remains well anchored and that real yields remain low by past standards. Accordingly, it seems that we’re not yet at the point where Fed policymakers feel the need to step in to shore up the bond market. It’s not clear where that point lies but a further increase in yields – and a tightening in financial conditions – over the coming weeks would quickly test its resolve.
The situation facing other countries is different. The recent rise in bond yields has its roots in the US and has been fuelled by a growing view that President Biden’s fiscal plans will lead to faster economic growth and higher inflation there. But, despite these American roots, the bond sell-off has had global spillovers. Bond yields in other advanced economies have been dragged up alongside those in the US, yet none of these countries stand to benefit from a fiscal boost worth up to 9% of GDP. (See Chart 1.)
Chart 1: 10-year government bond yields (%)
In some respects, this makes the response by central banks easier: in the absence of an impending boost to growth and inflation from looser fiscal policy, they should simply push back against the rise in yields. However, this is easier said than done. Once again, the difficulty lies in knowing when and what to respond to.
The task is made easier when central banks have an explicit target for yields at a particular part of the curve. The RBA responded to the bond sell-off by stepping up its asset purchases in order to keep yields at its three-year target. In contrast, the ECB has struggled to articulate at what point and in what circumstances it would respond to rising yields. This in part reflects the inherent ambiguity of its policy of implicit yield curve control. This is not an insurmountable problem and we expect that the ECB would ultimately increase purchases under its PEPP should bond yields continue to increase. But it illustrates the difficulties of formulating and coordinating a policy response to rising yields across 19 countries when there is no pre-defined target or pre-agreed framework.
However, the real challenge comes in countries that have borrowed in US dollars and now face higher borrowing costs as a result of the rise in dollar-denominated bond yields. These countries tend to sit in the emerging world. In recent years emerging markets have strengthened their balance sheets and dollar debt burdens have fallen. But there are a handful of countries that still suffer from what economists call “original sin”. These tend to be relatively small as a share of world GDP and won’t move the needle on the global recovery. Argentina is a perennial “sinner” but other countries at risk also include Kenya, Ghana and Tunisia. The rise in yields so far has not been large enough to precipitate balance of payment crises in these countries. But should yields continue to rise they will face an unenviable choice between raising domestic interest rates or letting their exchange rates weaken, which will exacerbate currency mismatches on their balance sheets. Either is a recipe for a sharp economic downturn.
If bond yields continue to rise, not only will the policy response differ between countries, but so will the extent of the economic pain.
In case you missed it:
- Our Senior China Economist, Julian Evans-Pritchard, argues that the main takeaway from the opening of last week’s National People’s Congress is the planned withdrawal of policy support for China’s economy.
- Our Chief Markets Economist, John Higgins, revisits Gordon’s Dividend Discount Model to explore the link between economic growth, bond yields and the outlook for equities.
- Our Chief US Economist, Paul Ashworth, explains why despite the passing of a $1.9trn stimulus bill we won’t be revising up our above-consensus forecast for US GDP growth this year.