What Drives Government Bond Yields?

For us the main three drivers of government bond yields are:

1. Inflation expectations.
2. The net international investment position (2a) and change in this position, namely the current account balance (2b).
3. Foreign debt relative to GDP.

Criterion 1: High inflation increases government bond yields

Especially local investors want to be compensated for rising inflation; therefore, government bond yields for countries with relatively low risk, often increase in synch with inflation. Strong GDP growth usually leads to less unemployment and higher inflation (at least when the country is a relatively closed economy). For a closed economy, cheaper imports thanks to a stronger currency do have a big influence, while an appreciating currency in an open economy like the Swiss one helps to contain inflation despite high GDP growth.

Interest Rate Minus GDP Growth for 23 OECD Countries (source OECD)

Expected Inflation & Real Interest (source Cleveland Fed)

Interest Rate Minus GDP Growth Differential Greece (Griechenland) vs. Germany 1991-2010

Criterion 2: A weak net international investment position (NIIP) and a current account deficit increases government bond yields

The following graph shows the cumulative current account surplus for different countries in percentage of GDP since the year 1970.

Cumulative Current Accounts for different countries

The following table indicates the cumulative current accounts for the strong exporter countries and for the weakest ones.

The net international investment position (criterion 2a) is the long-term result of the yearly current account balances (criterion 2b) and therefore far more important for yields.

Private savings mostly remain in the local economy and finance investments

Local investors increase their wealth when local firms achieve current account surpluses. Usually investors prefer to save money in the local currency and buy stocks of local firms. To get a full understanding it is advisable to grasp the relationship between private savings and current accounts (read here).

There are a few exceptions to this rule, e.g.:

• When U.S. money was invested in Europe in the 1970s to avoid high U.S. inflation and take profit on higher European growth (which led to the breakdown of the Bretton Woods system).
• During  the carry trade between 2003 and 2007 when the yen and the Swiss franc were used to finance higher yielding investments abroad.
• During the strong growth phase of emerging markets between 2009 and 2011 sustained by cheap U.S. quantitative easing money.

Loanable funds theory (“Saving finances investment”) 

 According to the “saving-finances-investment”-theory (often called the loanable funds theory), households have to save first, bring their money to the bank so that firms can borrow and invest – as long as government deficits have not taken away the precious savings from firms. From this it follows that more household saving and lower government deficits are the best way to promote investment: More saving leads to a higher supply of credit and thus more investment. Zero government deficits avoid crowding out private investment. And so if investment is not high enough, both households and the government should save more by cutting their spending and thus allow banks to increase credit. …

This is the paradox of thrift: households’ plans to save more leads to a decrease in aggregate revenues and expenditures – and no financial saving has actually taken place. Since firms are also likely to cut back their investment, overall saving will have fallen. The government could of course counteract the whole process by spending more where households spend less – but if the government also believes in loanable funds theory, it will cut spending itself and consequently the private sector’s revenues – welcome in recession-land. Or rather: welcome in euro-land. (source)

This paradox of thrift happened in the European periphery, especially in Greece, Spain and Portugal: both households and government spent less, while banks were still short on giving credit, because loans were often funded by foreign money. The weak countries had continuous current account deficits and not enough local funds available.

This leads directly to the third criterion.

Criterion 3: High foreign debt slows GDP growth and increases government bond yields

The debt argument can be applied on total debt or on debt held by foreign investors. The protagonists of this theory are Reinhard and Rogoff. They proved a link between debt and growth:

In a new paper presented Monday at the annual meeting of the American Economic Association, Carmen Reinhart of the University of Maryland and Kenneth Rogoff of Harvard study the link between different levels of debt and countries’ economic growth over the last two centuries. One finding: Countries with a gross public debt debt exceeding about 90% of annual economic output tended to grow a lot more slowly. For advanced countries above the 90% threshold, average annual growth was about two percentage points lower than for countries with public debt of less than 30% of GDP.
The relationship between government debt burdens and growth is even stronger for emerging-market economies, Ms. Reinhart and Mr. Rogoff find. For countries above the 90% threshold, average annual growth was about three percentage points lower than for countries with public debt of less than 30% of GDP. The countries above the threshold also experienced much higher inflation: prices rose more than twice as fast as in countries with small debt burdens. (source WSJ)

Government Debt holdings abroad

Check here for Roggoff's Reinhard's book.

The following graph from McKinsey shows the composition of total debt, government, households and financial debt, for different countries:

The Bank of Japan alone holds 30% of government debt, so that the Japanese net public debt is far lower than 220%. Adam Posen, the chief of the influential Peterson institute, even thinks that net debt is around 130 percent.

We reckon that high private and public debt will hamper spending and growth in many countries in the next few years. For us the importance is a new rational behaviour that leads to a new financial cycle. However this does not imply that government bond yields will rise; quite the contrary, thanks to low inflation they will remain low, except for countries where foreign debt is too high.

Will public debt be more important than NIIP, current account, savings and inflation?

After the financial crisis, risk has become a very important criterion for the valuation of currencies. The Czech economist Tomáš Sedláček reckons that the Western governments adopted a perverted version of a main Keynesian principle. In most countries debt rose between 1998 and 2007 during good times. But after the financial crisis, governments used Keynes’ argument to increase debt even further.

Therefore economists like Kyle Bass of Hayman Capital insist that in the future mainly government debt levels, our criterion 3, will be the main driver of government bond yields, at least for the Japanese example from the moment when criterion 2b, the current account balance, becomes negative.