For us the main three drivers of government bond yields are:
- Inflation expectations.
- The net international investment position (2a) and change in this position, namely the current account balance (2b).
- 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.
The Cleveland Fed’s estimate of inflation expectations is based on a model that combines information from a number of sources to address the shortcomings of other, commonly used measures, such as the “break-even” rate derived from Treasury inflation protected securities (TIPS) or survey-based estimates. The Cleveland Fed model can produce estimates for many time horizons, and it isolates not only inflation expectations, but several other interesting variables, such as the real interest rate and the inflation risk premium.
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.
The following table indicates the cumulative current accounts for the strong exporter countries and for the weakest ones.
Country Cum. Curr. Acc. bn$ Population mil. per capita
Top of list (positive cum. current accounts) Japan 2747.943 127.694 21520
China 1521.887 1327.658 1146
Germany 1047.328 82.120 12754
Russia 613.978 142.000 4324
Switzerland 596.977 7.310 81666
Netherlands 523.055 16.704 31313
Saudi Arabia 451.337 24.897 18128
Norway 444.011 4.799 92522
Taiwan (Republic of China) 365.121 23.037 15849
Kuwait 346.713 3.443 100701
Singapore 309.727 4.668 66351
United Arab Emirates 257.365 4.764 54023
Sweden 232.236 9.179 25301
Venezuela 191.734 28.050 6835
Hong Kong SAR 188.310 7.009 26867
Belgium 186.513 10.750 17350
Qatar 145.276 1.098 132310
Finland 85.127 5.270 16153
Bottom of list (neg. cum. current accounts) Iceland -21.983 0.316 -69566
Canada -56.757 33.260 -1706
South Africa -69.912 48.687 -1436
Argentina -72.486 39.746 -1824
Hungary -91.720 10.055 -9122
New Zealand -95.316 4.276 -22291
India -137.796 1190.451 -116
Poland -182.901 38.100 -4801
Portugal -187.217 10.631 -17610
Turkey -192.089 69.659 -2758
Brazil -220.506 191.870 -1149
Greece -249.371 11.172 -22321
Italy -262.901 59.336 -4431
Mexico -263.667 106.316 -2480
Australia -529.031 21.323 -24810
United Kingdom -695.155 61.073 -11382
Spain -773.443 45.618 -16955
United States -7,335.869 304.415 -24098
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)
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.
Moreover he claims that the level for total government debt, not only the level of foreign debt, is important.
In a new investor letter – posted on ZeroHedge – Bass takes aim at critics who think that Japan (or the US, presumably) can create money at will, and not have to worry about their burgeoning national debt loads.
“The fallacy of the belief that countries that print their own currency are immune to sovereign crisis will be disproven in the coming months and years. Those that treat this belief as axiomatic will most likely be the biggest losers. A handful of investors and asset managers have recently discussed an emerging school of thought, which postulates that countries, as the sole manufacturer of their currency, can never become insolvent, and in this sense, governments are not dependent on credit markets to remain fiscally operational. It is precisely this line of thinking which will ultimately lead the sheep to slaughter. ”
Kyle Bass’ arguments are rejected by many opinion leaders that maintain that inflation remains far too important as a driver for government bond yields for countries with low foreign debt:
Another way of saying this is that Japan and the USA cannot “run out of money” while a nation like Greece most certainly can. There is a very real solvency constraint in Greece so bond traders have different concerns than they might in Japan or the USA. It’s been widely reported that Hayman’s funds have suffered substantial losses in the last few years in large part due to this trade. The flaw in the Kyle Bass thesis is that interest rates will surge due to market fears over high debt. But seasoned bond traders know that solvency is not the concern in a nation like Japan or the USA. They know that these nations cannot run out of money due to institutional design. So the focus then, is always inflation. And the reason Japan’s bond market has continued to rally throughout the years is due to persistent stagnant economic conditions and low inflation as a result. We feel that the environment in the USA is remarkably similar to the environment in Japan. But more importantly, we must note that it is crucial to understand this institutional design structure before entering into potentially misguided trades based on an apples to oranges (Europe vs Japan) comparison.
Cullen Roche, ORCAM Macro, Is it Time to Take on the “Widow Maker”?, Online
Mankiew Greg, Harvard University and NBER & Douglas W. Elmendorf, Federal Reserve Board: Government Debt, Online
University of Harvard: Papers of Kenneth Roggoff
Disclaimer: The opinions expressed above are not intended to be taken as investment advice. It is to be taken as opinion only and we encourage you to complete your own due diligence when making an investment decision. Even if we often write about Forex trading, our advices aren't written for day traders who follow technical channels, but rather for mid- and long-term investors. Our aim is to show discrepancies between fundamental data and current asset valuations, which can lead in mid-term to an inversion to technical channels.