Higher bond yields and higher inflation mean higher national debt costs

The last week or so has brought a theme of this blog back to life and reminds me of the many years I spent working in bond markets. They have spent much of the credit crunch era being an economic version of the dog that did not bark. Much of that has been due to the enormous scale of the QE ( Quantitative Easing) sovereign bond buying policies of many of the major central banks. The politicians who came up with the idea of making central banks independent and then staffing them with people who were anything but should be warmly toasted by their successors. The successors would never have got away with a policy which has benefited them enormously in terms of ability to spend because of lower debt costs.

Italy

However the times are now a-changing and this morning has brought more bad news on this front from Italy. The BTP bond future for December has fallen to 120 which means it has lost a bit over 7 points over the last ten or eleven days. Putting that into yield terms it means that the ten-year yield has reached 3.5% which has a degree of symbolism. A factor in this is described by the Financial Times.

The commission issued its warning to the Five Star and League governing coalition after Rome deviated from the EU’s fiscal rules by proposing a budget deficit equivalent to 2.4 per cent of gross domestic product instead of the 1.6 per cent previously mooted by the finance minister Giovanni Tria. Although the new plans keep Italy under the EU’s 3 per cent deficit threshold, the country’s high debt levels — the highest in the eurozone after Greece — means Rome is required to cut spending to bring debt levels gradually lower.

However the chart below tells us that in fact you can look at it from another point of view entirely.

Actually I think that the situation is more pronounced than that as the ECB has bought 356 billion Euros worth. But you get the idea. It is hard not to think that a major factor in the recent falls is the halving of ECB QE purchases since the beginning of this month and to worry about their end in the New Year. In case you were wondering why the share prices of Italian banks have been tumbling again recently? The fact they have been buying in size in 2018 when one of the trades of 2018 has been to sell Italian bonds gives quite a clue.

If we switch to the consequences for debt costs then a rough rule of thumb is to multiply the 3.5% by the national debt to GDP ratio of 1.33 which gives us 4.65%. In practice this takes time as there is a large stock of debt and the impact from new debt takes time. For example Italy issued 2 billion Euros of its ten-year on the 28th of last month at 2.9%. So a fair bit less than now although much more expensive that it had got used too. This below from the Italian Treasury forecasts gives an idea of how the higher yields impact over time.

The redemptions in 2018 are approximately €184 billion (excluding BOTs) including approximately
€3 billion in relation to the international programme……..the average life of the stock of
government securities, which was 6.9 years at the end of 2017.

Oh and the tipping point below has been reached. From the Wall Street Journal.

Harvinder Sian, a bond strategist at Citigroup, thinks a 10-year yield of 3.5%-4% is now the tipping point, after which yields jump toward the 7% reached at the height of the last euro crisis

Personally I am not so sure about tipping point as the “gentlemen of the spread” ( with apologies to female bond traders) have been selling it at quite a rate anyway.

 

The United States

Here bond yields have been rising recently and let us take the advice of President Trump and look at what has happened during his term of office. Whilst back then Newsweek was busy congratulating Madame President Hilary Clinton my attention was elsewhere.

There has been a clear market adjustment to this which is that the 30 year ( long bond) yield has risen by 0.12% to 2.75%.

We see that it has risen in the Trump era to 3.4% although maybe not by as much as might have been expected. However if we look to shorter maturities we see a much stronger impact.For example the two-year now yields some 2.9% and the five-year some 3.07%. So if you read about flat yield curves this is what is meant although it is not (yet) literally true as there is a 0.5% difference. Thus the US now faces a yield of circa 3% or so looking ahead. This does have an impact as the New York Times has pointed out.

The federal government could soon pay more in interest on its debt than it spends on the military, Medicaid or children’s programs.

In terms of numbers this is what they think.

Within a decade, more than $900 billion in interest payments will be due annually, easily outpacing spending on myriad other programs. Already the fastest-growing major government expense, the cost of interest is on track to hit $390 billion next year, nearly 50 percent more than in 2017, according to the Congressional Budget Office.

If we switch to the Congressional Budget Office it breaks down some of the influences at play here.From its September report.

Outlays for net interest on the public debt increased by $62 billion (or 20 percent), partly because of a higher rate of inflation.

The CBO points out a factor the New York Times missed which is that countries with index-linked debt are also hit by higher inflation. As the US has some US $1.38 trillion of these it is a considerable factor.

Also the US is borrowing more.

The federal budget deficit was $782 billion in fiscal year 2018, the Congressional Budget Office estimates,
$116 billion more than the shortfall recorded in fiscal year 2017………The 2018 deficit equaled an estimated 3.9 percent of gross domestic product (GDP), up from 3.5 percent in
2017. (If not for the timing shifts, the 2018 deficit would have equaled 4.1 percent of GDP.)

Higher bond yields combined with higher fiscal deficits mean more worries about this factor.

At 78 percent of gross domestic product (GDP), federal
debt held by the public is now at its highest level since
shortly after World War II. If current laws generally
remained unchanged, the Congressional Budget Office
projects, growing budget deficits would boost that
debt sharply over the next 30 years; it would approach
100 percent of GDP by the end of the next decade and
152 percent by 2048 . That amount would
be the highest in the nation’s history by far.

I counsel a lot of caution with this as 2048 will have all sorts of things we cannot think of right now. But the debt is heading higher in the period we can reasonably project and I note the CBO is omitting the debt held by the US Federal Reserve so that QE would make the figures look better but the current QT makes it look worse.

Comment

Debt costs and the associated concept of the mythical bond vigilantes have been in a QE driven hibernation but they seem to be showing signs of waking up. If we look at today’s two examples we see different roads to the destination. If we look at the road to Rome we see that the longer-term factor has been the lost decades involving a lack of economic growth. This has made it vulnerable to rising bond yields and which means that the straw currently breaking the camel’s back has been what is a very small fiscal shift. It is also a case of bad timing as it has taken place as the ECB departs the bond purchases scene.

The US is different in that it has a much better economic growth trajectory but has a President who has also primed the fiscal pumps. Should it grow strongly then the Donald will win “bigly” as he will no doubt let us know. However should economic growth weaken or the long overdue recession appear then the debt metrics will slip away quite quickly. That is a road to QE4.

Returning back home I note that UK Gilt yields are higher with the ten-year passing 1.7% last week for the first time for a few years.So the collar is a little tighter.The main impact on the UK came from the rise in inflation in 2017 leading to higher index-linked debt costs. This was the main factor in our annual debt costs rising by around £10 billion between 2015/16 and 2017/18.

 

 

 

 

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23 thoughts on “Higher bond yields and higher inflation mean higher national debt costs

  1. Hi Shaun

    Great article as always.

    The uk is going to use brexit as an excuse to pump £750bn of QE back into the economy. Do you think the ECB will reverse its policy, print and buy bonds again?

    • Your blog crossed with mine! A good point about the ECB – looking at that graph, what on earth will happen if it doesn’t reverse policy and go for more QE? I don’t think that QE is very easy to reverse and the USA seems to be the only one able at present to do this.

  2. That graph of Italian bond purchases is really incredible. As I read it:
    1. The Italian banks have chosen 2018 to go back into bonds…
    2. The ECB has not only picked up the entire new issuance, but has also bought out about 100 billion of non-bank Italian holders.
    3. The scale of the falsification of bond yields must be enormous
    In effect, the ECB has funded the Italian deficit for years and has reduced that deficit by forcing down yields on borrowing, so the ECB withdrawing could have an extraordinary effect, as the Italian government would need to borrow all of its money from sources that don’t exactly look willing in the graph to buy.
    On top of that, has anyone told the German voter? I am not sure that they would be happy to realise that the scale of ECB intervention means that the ECB itself is pretty vulnerable to an Italian default (ie German taxpayers will be asked to cough up)…
    Where will it all end?

    • Yes, I agree the chart shows that to me as well. Hence I guess the strength of the ECB position on the matter. However I guess if you don’t tell the voters that “Uncle ECB” has been funding “their excess” for years then the voter might not know it.

      It is also might be that the rather populist voter could say, you what? Someone in the Italian Govt has taken €250bn to prop up the status quo. We never voted for that!

      • I know that we don’t do politics on this site but it seems to me that it may become irresistible for Italian politicians to point out that there probably isn’t a lot the ECB can do short of declaring war if Italy drops the euro and unilaterally states that it will only pay the ecb back in lira…
        The other reason why the ECB may take a hard line is that, if Italy can get away with higher budget deficits, why not everyone else.

  3. Looking at the share price of German banks today
    Commerzbank open 8.91
    high 8.92
    low 8.44 at 13.00

    Deutsche bank open 9.66
    high 9.67
    low 9.48 at 13.00

  4. Italy needs growth to counteract the high unemployment and demographic issues it faces and with interest rates still near the zero lower bound it should be up to fiscal policy to step into the breach, despite the future effects on the debt interest burden.

    However being constrained by EU and EZ rules this out, but to put a nation like Italy into a box like this is unconscionable. What seems to be going on at the moment is kabuki theatre between the EU and Italy with Italy edging ever closer to the Euro exit door. Leaving the Euro would allow the devaluation of a “new Lira” and give another major string to the bow of growth. The further, nuclear option of outstanding debt redenomination is also not out of court and this would really stir the EZ but of course Italy cannot be bullied in the same way as Greece.

    The UK is in a similar position but without the incubus of the Euro. At the ZLB fiscal policy should take the strain but should only do so on the basis of running countervailing surpluses when growth is strong, something we seem quite unable to do. At some point debt interest will crowd out other spending and this will bring the pains on.

    The US like the UK is going to run up against reality fairly soon; the budget deficits are exploding and Trump will soon have to look at retrenchment otherwise the dollar will collapse, interest rates will rise and the debt interest burden will take off.

    It appears not to have dawned yet to many that we may well be entering a low growth era where the main task is not to fulfil expectations but to manage them down.

    • What do you mean “entering” ?

      apply Forbin’s fiscal GDP correction and you’ll see we have been flat or declining for years- only a slight uptick lately

      Still , gotta laff , wait until oil takes off ……ehehehehe

      Forbin

      PS: We have also the new “China Syndrome” – debt hydrogen bomb
      and the Italians ……. hmmm interesting times…..

  5. As Treason May has just announced the end of “AUSTERITY” (don’t laugh 😂), presumably the intention is for fiscal expansion to be the stimulus now QE has run course, good job we haven’t already got a mountain of debt-oh wait……..

    • well as our illustrious leaders in the BoE have pontificated before
      QE was a sterilized instrument that was just passed around the TBTF Banks and the BoE

      no real world impact at all , no sir ree , non at all, any impact you may think happened was just a figment of you imagination

      who you’re gonna believe their “expert” word or you lying eyes ?

      So the stage is set for some real proper fiscal expansion …..

      tin hats on lads!, INCOMIIIIIING !

      Forbin

  6. One of my favourite reads. Shaun you are consistently very good and exceptionally well informed with an amazing breadth of coverage.

    I’d love to hear your views on the news that Mr Haldane has been appointed to chair a committee to investigate the “productivity puzzle”.

    • which means we have a blind man leading the blind ……

      There’s no puzzle – except the look on his face as reality rears its ugly head….

      Forbin

      • Maybe they’ll have that Eureka moment and figure out they’re the problem.

        I do hope Italy is going to be the nation to push the Ponzi economy over, getting tired of waiting.

    • I am sure that he’ll do a fine job. After all, it’s not as though he’s been in an ivory tower all his life – he only joined the BoE in 1989 after a glittering career in the real world, er, straight from uni…

  7. Hi Shaun,
    Prescient subject today given the movement in Italian yields. I am having trouble computing all the macro effects of the policy approaches around the world.

    USA has started the shift instability with Trumps attempt at reflation and re-shoring. The US QE spread around the world inthe Obama years and got the EM’s hooked on cheap dollar. Hawks in the US think they can win an economic battle with the imperialist expansions of China by a tariff trade war, and facilitating re-shoring of production. The higher petro-dollar is stressing EM’s and especially those low on oil reserves when you include the higher barrel price. USA has also promoted return of dollar via low taxation incentives, along with QT and appreciating yields these are serving to attract even more funds into the Trump vortex. The other side of the coin is that Trump has embarked on a deficit-led fiscal expansion which has pump-primed the entire economy sucking in orders and workers creating inflation and interest rate rises in turn causing much higher Govt debt payments (which are already exceeding Govt Tax income). Some forecasters worry about a QE4 remedy to rescue the US at the end of its trajectory to the stars – and subsequent loss of reserve currency status.

    EU and UK have become caught following the QE path set some 5 years ago in the US and the divergent paths are now becoming so very clear…. slow to tighten, slow to raise. Is Europe de-coupled from the US now, can they live in “print money and dream about ZIRP” world? The ECB has funded southern Europe through the grim years of the GFC to a stasis of low growth and low exectations, its handout societie’s are addicted to both deficit and support. Attempts to further control Italy fall now on deaf ears because the ECB bond buying was invisible to the populace, that supra-national organisations were distributing financial palliatives is plainly incredible to many regular people because all they saw was the grey sameness of austerity. So does the whole of Europe have to pay more for its money if Italy do?

    China is taking a number of hits simultaneously; Trumps tariffs are hitting competitiveness, they also spotted the Minsky moment a year ago and have had to rein-in shadow-banking, their belt and road project was too ambitious and many EM’s can’t pay won’t pay which is hitting ROI vehicles. They still can’t resist printing money but deploying it selectively to keep all parts of the present economy in balance. They also hold rather a lot of US treasuries and so must be watching with concern about the Trump reflation show. Lastly they must be redoubling efforts to make the RMB a tradeable currency to control resource costs and free themselves from the petro-dollar. I can see China buying Iran oil for RMB if Trump continues to stop taking it.

    Where is the show going….?

    • Hi Paul C

      The China news over the weekend was intriguing ( for those unaware there was some monetary easing mostly via another drop in bank reserve ratios), That sort of thing did not do us western capitalist imperialists much good did it?

      The Italian saga has returned to some of my old bond market rules. We had a DCB ( with apologies to feline lovers that stands for Dead Cat Bounce) last week which then began to fizzle out and on Friday we saw more falls, or putting it another way people were afraid of holding over the weekend. So today should have brought a rally whereas it soon headed south and ended up some 1.6 points lower in futures terms.

      So the bond market still looks weak. However down at these levels there is the danger of an ECB inspired rally and we could gain a couple of points both easily and quickly. But unless it backs it up we will start fallin’ again.

  8. Hello Shaun,

    Perhaps it’s time to take this to the TBTF Banks and their followers…..

    be inspired !

    From far away In mountains deep
    The night of blood In twilight sleep
    The armies fight For king and queen
    There will be no No victory
    The swords collide With power and force
    As mighty men Show no remorse
    It is the time The snow is melting
    It is the time Of reckoning

    Forbin

  9. Great blog, Shaun, as usual.
    The Ontario debt may be of some interest to your readers if only because it is said to be the largest debt burden of any subnational government in the world. (It’s not hard to believe.) The Report of the Independent Financial Commission of Inquiry:
    https://www.fin.gov.on.ca/en/report/ifci-2018.pdf
    was received by the Ontario Finance Minister on August 30 and released on September 21. It notes that: “The cost of Ontario’s debt will increase if borrowing rates rise as expected. To manage its cost of borrowing, Ontario has issued approximately $10 billion per year of bonds with maturity terms of 30 years or longer since 2010–11, effectively locking in low interest rates. The 2018 Budget anticipated incurring $12.5 billion in interest costs in 2018–19. This means that 7.9 per cent of the Province’s total expenses would go to servicing the debt rather than paying it down, investing in new or enhanced services, or reducing taxes…As interest rates are outside the Province’s control, the most powerful lever the government has to manage its borrowing costs is to reduce its debt.” The rising interest rates are likely to reduce the province’s revenues as well as increase its costs as they will dampen nominal GDP growth.
    The report provides no details but the spring 2018 economic outlook of the Financial Accountabiity Officer, unfortunately still the most recent, forecast the 10-year Government bond rate would go from 1.8% in 2017 to 3.5% in 2022. Interest on debt payments were forecast to grow by 4.4% on average from 2017-18 to 2020-21, partly due to increased interest rates and partly to increased provincial debt.

    • ” …Interest on debt payments were forecast to grow by 4.4% on average from 2017-18 to 2020-21…”

      and they are not alone and we are told this is not a problem…..

      God help us all – for mortals will not

      Forbin

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