Bond Yields, Debt Supply, and Inflation

April 19, 2011

The ten-year bond yields in the United States, Germany, Britain, and Japan remain low despite higher inflation and rising concern about the sustainability of excessive fiscal deficits and debt.  Bond spreads have not shifted materially among these four advanced economies, either.

The table below compares the current sovereign ten-year yields to period averages since 1990.

  U.S. Germany Britain Japan
1990-94 7.26% 7.62% 9.23% 5.44%
1995-99 6.04% 5.55% 6.69% 2.29%
2000-04 4.77% 4.60% 4.87% 1.38%
2005-07 4.57% 4.79% 4.64% 1.60%
2008 3.65% 4.00% 4.49% 1.49%
2009 3.24% 3.27% 3.60% 1.35%
2010 3.19% 2.78% 3.52% 1.18%
1Q11 3.44% 3.18% 3.65% 1.25%
Apr 19, 2011 3.37% 3.28% 3.56% 1.24%

 

Two observations can be seen readily.  First, sovereign debt yields remain far below levels in the early nineties and the early noughties even though both of those earlier periods encompassed mild recessions and the Great Recession ended almost two years ago.  Second, yields now are not even materially above their average levels in the first quarter of 2011 in spite of a deepening European sovereign debt crisis and mounting evidence of rising world inflation.  In the month between March 18 and April 18, the Greek and Portuguese ten-year debt premiums vis-a-vis German bunds widened 228 basis points and 174 basis points to 1131 and 615 basis points, respectively.  Spanish and Portuguese spreads are wider much wider than a week ago.  Meanwhile, U.S. consumer prices between December and March (that is during 1Q11) rose at an annualized rate of 6.1% compared to 3.3% in 4Q10, and core inflation accelerated to 2.0% from 0.8%.  Food and energy prices soared by 7.5% and 42.4% annualized in the most recent quarter.

One can draw a number of inferences.

  • Investors see a much clearer and present danger in the debt problems of Euroland’s peripheral members than America even after S&P’s warning that time is running out for U.S. legislators to put a credible plan of fiscal reduction in place and avoid a credit rating downgrade.

 

  • Euroland fails to get the benefit of any doubt, revealing investor discomfort with the disconnection between a single monetary policy juxtaposed against the fiscal policies of 17 different sovereign states.  Euroland is further disadvantaged because currency depreciation is not an available tool to counterbalance fiscal austerity and rising short-term interest rates with strengthening export competitiveness.  Eventual defaults are considered far more probable in Greece and other peripherals than in America.

 

  • The full impact of a change in inflation on bond yields isn’t felt for a considerable period — years instead of months — because it takes a long time to dislodge expected inflation.  U.S. inflation decelerated from 3.5% per annum in the first half of the nineties to 2.4% per annum in the second half of the decade.  2.4% happens to match the average rate of inflation over the ensuing eleven years to end-2010 as well, but the 10-year Treasury yield continued to drop, averaging 3.44% last quarter versus 4.77% in the first half of the noughties.

 

  • Except at the extreme when default is a clear and present danger, the effect of debt supply on long-term interest rates is vastly over-rated.  U.S. yields fell last decade despite the federal budget’s swing from large surplus to massive deficit.  Japanese debt now hovers near 200% of GDP after two decades of stimulative fiscal policy and abnormally low economic growth, but JGB yields are lower than 1.5% in part because government debt is held mostly by the Japanese themselves.  German and British public finances also looked better in 2000 than now, which didn’t prevent their downwardly trending long-term rates.

 

  • Drawing inferences from past history can lead to a false sense of safety.  One wild card is the intangible benefit of quantitative easing, which puts direct upward pressure on bond prices by increasing demand.  Japan has managed to sustain quantitative easing on and off for a decade because deflation sets that economy apart from all others.  The United States and Europe might have regressed into deflation if their central banks had not stimulated aggressively.  But that wasn’t the road authorities took, and quantitative easing is soon going to end.  When the BOJ stopped the practice in 2006, Japanese bond yields didn’t shoot up because the removal was attempted before all embers of deflation had flamed out.  That’s clearly not the case in the United States where the third quarter this year looms as a big test for Treasuries.  Not only must a budget-cutting plan be wrapped up by summer lest the window of opportunity for striking a deal close but markets will by then lose the support of quantitative easing.

The interplay of debt supply and inflation as causal determinants on long-term interest rates along with real economic growth and monetary policy is a story that’s still evolving.

Copyright Larry Greenberg 2011.  All rights reserved.  No secondary distribution without express permission.

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