ExplainSpeaking | The danger of rising US government bond yields — for the world and for you - The Indian Express
Over the past couple of months, there has been a growing worry about the rise in government bond yields across the world.
A government bond is a document where a government acknowledges that it is taking a loan from someone and details how much it will pay back and by when. It borrows to meet the gap between what it spends (on everything from defence to subsidies) and what it earns (from levying taxes).
The yield on a government bond refers to the interest rate that a government has to pay. Rising yield on bonds means that the government will have to shell out more money as interest payment; it is similar to your car or home loan EMI going up when the bank tells you that interest rates have been increased. In both cases, the borrower (the government or you) must keep aside more money next month to pay back the lender.
Another direct fallout for higher interest payment is that the borrower will have less left for other activities (be it road construction or the government taking care of the poor or you having less money to buy books or traveling with your family).
It also follows that up to a point, increases in interest rate, while uncomfortable because they make you pay more on the same loan, are manageable. But there is always a tipping point — if the rates continue to rise beyond it, neither the government nor you will be able to manage their respective budgets.
There is an additional sting when interest rates go up for the government, as against when they go up for you alone: When they go up for the government, they go up for everyone (including you) in the economy.
Why? Because lending to the government is the safest kind of lending there is. As far as the ability to pay back a loan is concerned, a government borrowing money in its own currency is almost certain to always pay back the loan. After all, unlike you or every other borrower, including the biggest companies, the government has the superpower to print its own money.
So if the interest rates on the safest loan are going up, lenders start demanding higher rates from all others as well. This not only means higher EMI for existing car or home loans but also for newer loans of all manner. A young entrepreneur wanting to start up an innovative business will find that either the funding has dried up or become too costly. In other words, beyond a certain point, rise in government bond yields can drag down the whole economy.
Here’s a further kicker. If the government in question is the United States government then the ramifications of higher yields on US government bonds are not limited to just the US economy; they start affecting all other economies and their constituents, even those in a land far far away from Washington DC.
That’s because while a government is the safest entity to lend to in any economy, at a global level, there is a gradation for governments as well. Not all governments are equally credit-worthy. Imagine lending money to the Pakistan government for a period of 10 years in 1965! There are many instances of governments defaulting on their loans. There are also instances of governments ceasing to exist because the country itself stopped to exist or broke into two or more countries.
In that sense, the US government is the safest borrower in the world. It has been considered so safe that parking your savings in lending to the US government has often been considered as safe as investing in gold.
When the yields go up for US government bonds, lenders typically ask for higher interest rates from every government on the planet because the whole spectrum is riskier. And that is what is happening at present.
CHART 1 shows the yield for the 30-year US government bond — that is, a bond whereby the US government borrows money for a period of 30 years — going up to the highest it has been since the global financial crisis in 2008.
Similarly CHART 2 shows the yield for 10-year US government bonds going up sharply since February this year. CHART 3 shows the yield for a 10 year bond in the United Kingdom mapping a similar trajectory.
CHART 4, which shows the yields for 10 year Japanese bonds, looks less dramatic but is even more so in reality because these yields have risen to levels last seen in the mid-1990s.
The evidence feeds into the apprehension that the global bond markets (basically a collective term referring to all the investors who lend money to governments) are in the mood to punish governments by asking for a higher interest rate.
In fact, the rise in bond yields was so sharp that, when asked about it on August 21, US President Donalf Trump threatened military action against the bond markets. “We have many types of intervention. That’s one. The ultimate intervention is our military. And if we have to use that, we will,” he said.
But can the armies of the world tame the bond markets?
“I used to think that if there was reincarnation, I wanted to come back as the president or the pope… But now I would like to come back as the bond market. You can intimidate everybody,” said James Carville in 1993 soon after he successfully helped Bill Clinton’s presidential bid as his campaign manager.
Threatening or killing the money-lender to bring down interest rates might seem like a straight-forward if brutal solution, it is not quite practical when it comes to the bond markets and how they function.
In fact, Trump’s statement further spooked the bond markets, presumably because it further eroded the US government’s credibility and willingness to play by the rules.
Government bonds — called by different names across countries, such as Treasuries in the US, Gilts in the UK, Bunds in Germany, and G-Secs in India — have a simple structure.
A bond is essentially a formal I-O-U (or I owe you) between the government issuing the bond and the entity lending the money. The government states the money it is borrowing — say $100 — the period for which it is borrowing — say 10 years — and the additional money that the government will pay to the lender each year over and above the $100 at the end of the tenure.
This additional money is called the coupon and, crucially, it is an absolute amount — say $10. In other words, instead of saying that the government will pay 10% interest each year, the government says it will pay $10.
This distinction matters because government bonds are tradable. A person can lend the money to the government, get the bond in return, and then sell the bond in the open market — the proverbial bond market.
It is when the bonds start trading that bond yields come into the picture.
Imagine a scenario involving a global financial crisis (like in 2008) or a global pandemic (like Covid in 2020). All businesses stall, stock markets plummet, and people panic, wondering where to park their savings in such a manner that they don’t lose value. Historically, the first preference is to buy gold. But often the second preference is to buy government bonds. When the demand for bonds goes up in the market, so does their price. But as the price goes up, the yield falls. Here’s how.
Suppose the demand is so strong that someone is willing to pay $200 to you to purchase a $100 bond, which pays out $10 each year. As soon as this transaction happens, the price of the bond has doubled and the interest rate that it “yields” is just 5% — half of what it was yielding you when priced at $100.
Bonds of each country are traded on a daily basis. The ownership changes hands, including the likes of insurance and pension firms (where a common man invests for getting an old-age pension or a medical insurance), commercial banks and central banks, as well as retail investors.
The last crucial bit is the scale of the government bond market — the amount of money that is already out there, held by millions of investors. According to a report by the Organisation for Economic Co-operation and Development (OECD), the size of the government bond market for the 38 high-income OECD countries is $61 trillion. If one adds bonds from emerging economies, the number is close to $80 trillion.
But the scale of the market is even bigger because companies also float bonds to raise funding and it matters because when yields go up for governments, they go up for everyone else. If one adds bonds by all financial and non-financial institutions other than the government, the global bond market would reportedly double to $160 trillion. For reference, India’s total GDP is around $4 trillion, the US is around $32 trillion, and the world’s total GDP is $126 trillion.
Simply put, threatening military action on the bond market does not make any sense.
Just as yields go down when bond prices rise, yields go up when bond prices fall, as is happening now. Bond prices fall when no one wants to hold them or buy new bonds because they are not sure if the government issuing the bond will be able to honour the promise.
Given the scale of the market, even a single basis point increase in government bond yields — 100 basis points make a full percentage point — raises the interest payment (recall EMI) by billions of dollars for governments.
That is why governments are worried about yields rising sharply. CHART 5 shows how the US government’s average borrowing cost have gone up as the yields have risen in the recent past. Governments borrow for different time periods — ranging from a few days to years. The yields typically rise with tenure because investors want a higher rate of return if they are being asked to part with their money for a longer period.
This rising interest rate has resulted in higher interest payments each year. As CHART 6 shows, in 2010 the US government paid out $414 billion in interest payments on all the outstanding debt. This number has blown up, especially since 2022.
It is also helpful here to remember that governments have no money of their own; it is the taxpayers’ money. As such, if governments end up spending more on paying back the interest on past loans, they will have less money left to spend on any other policy concern such as providing better healthcare or education.
In fact, the US government now spends more of its annual budget on paying back interest on existing loans than it spends on the military. Further, as rising yields wreck government budgets, they are also threatening the viability of companies globally.
Sticking to the US, there are two main problems.
First is the sheer amount of debt in the market. The US continues to borrow more and more each year. CHART 7 shows how the US government has become increasingly dependent on borrowings to meet their expenses.
This annual budget deficit keeps adding to the stock of total US government debt. CHART 8 shows the level of total US government debt. At last count it had crossed $40 trillion — that’s half of the total government debt in the world. CHART 9 shows how it stands as a percentage of the total US GDP.
Jay Powell, who recently ended his term as the Chair of the Federal Reserve (The US equivalent of RBI), had said last year that the US debt trajectory is unsustainable.
Simply put, no government, not even the US, which otherwise enjoys complete trust from investors across the world, can keep borrowing at such levels year after year without investors demanding a higher rate of return (read yield).
The second problem is the falling credibility of the US government.
Typically, a higher amount of debt can be countered if it is used by an economy to grow faster. That way, the debt-to-GDP ratio (CHART 9) does not go up.
But what if government policies hurt growth even as the pile of debt grows? Several actions of the Trump administration have been viewed as detrimental to the overall prospects of the US economy, with equally severe ramifications for the global economy.
For instance, ad hoc imposition of punitive tariffs last year or launching the war in Iran this February not only disrupted long-established supply chains but raised costs and inflation globally, thus dragging down growth potential.
What has made matters worse in the past few months is that the Trump administration and his latest appointment to the US Federal Reserve, Kevin Warsh, have made statements and taken decisions that have betrayed a sense of desperation and denial of the problem.
For instance, Treasury Secretary Scott Bessent has tried to manipulate the bond markets to reduce yields by announcing a buyback of US bonds. The way this is intended to work is that the US government buys back its own bonds of longer tenure (and hence higher yields) and gets them money to do this by selling bonds of shorter tenure (and hence lower yields). Bessent expected a net result where overall borrowing costs (see CHART 5) come down.
But the bond markets saw through the desperation and yields shot up further. This move follows another controversial intervention by Bessent in the Japanese bond market in July. At close to 250%, Japan’s debt-to-GDP ratio is double that of the US.
The West Asia war and costlier crude oil have resulted in a sharp rise in inflation in Japan. Higher inflation basically means the Japanese yen is losing value, and so is any bond or asset that is denominated in the yen. This, in turn, led to the yen exchange rate falling against the dollar. In other words, relative to demand and supply of yen, the demand for dollars outstripped the supply for dollars.
To prevent it, Japan would have had to sell US dollar-denominated bonds to boost their exchange rate. But selling US bonds would have further reduced their price and increased yields. Bessent intervened to prevent Japan from selling US government bonds and, instead, had the US Treasury sell euros to prop up the yen exchange rate. He has also hinted that he knows that the Japanese central bank will raise interest rates soon. A higher interest rate is expected to curb inflation and calm the bond and currency markets.
But both his intervention, which incidentally blindsided the European policymakers, as well as his suggestion that he knows what Bank of Japan will do, further undermined the credibility of all concerned policymakers. With trillions of dollars on the line, the bond holders are increasingly concerned that the Trump administration is trying to impose its will on the market. A scared or angry bond holder is likely to demand higher returns not just from existing bonds but also from fresh borrowings; that means yields could go up even further.
Adding nervousness to this scenario was the lack of commitment — at least as the bond market participants saw it — on the part of Warsh to contain inflation by raising interest rates. Warsh’s appointment follows Trump’s repeated desire to see the US Fed cut interest rates.
To be sure, if central banks don’t raise interest rates to contain inflation in the short term, bond investors get understandably spooked about the state of the economy over longer terms, between five and 30 years. If policymakers allow for inflation to be higher than what is the target rate, then it not only drags down the economic growth but also reduces the real rate of return over the long term. Both are good reasons for investors to dump such bonds, resulting in higher yields and punishing governments via higher interest payouts.
The only military move that can actually work here is if Trump announced an end to the conflict in West Asia. It will immediately lower inflation and brighten growth prospects worldwide.
But given that the nature of the problem predates the war in West Asia, here are three things that should happen to bring down yields.
The US and, for that matter, most of the so-called rich countries, are sinking in debt. The first and foremost thing to do is reduce borrowing and possibly work towards having a surplus budget (see 2001 in CHART 7). This means not just cutting government expenditure and raising more revenues but also making both these processes more efficient.
As explained, debt matters. but a country can get out of a debt trap if it grows fast enough to bring down the debt-to-GDP ratio.
On Wednesday (September 16), the US Fed will have a chance to raise interest rates in the face of continually rising inflation in the US. Latest retail inflation data released on September 11 suggests that Warsh may not have any option left but to raise interest rates and possibly annoy Trump.
Even more importantly, Warsh would have to convince bond markets that he is committed to the US’ 2% inflation target.
On the fiscal policy side, Trump and Bessent have to ensure that they sound and look like they want to improve the situation — be it on growth or inflation.
It takes decades to achieve trust and credibility of the kind that the US enjoys. However, it can be lost in far less time if the Trump administration is not careful. The UK is a cautionary tale in this regard. The country has not recovered from the damage done by Prime Minister Liz Truss’s 2022 budget. In just a few weeks of her tenure, UK bond yields spiked and became the highest among the G7 countries; they have not come down since then.
What should Trump do in the second half of his tenure? Should he carry on with his interpretation of America First and Make America Great Again ideas? Share your views and queries at udit.misra@expressindia.com
Udit Misra is Senior Associate Editor at The Indian Express. Misra... Read More
