Paul Diggle

Hello and welcome to Macro Bytes economics and politics podcast from abrdn. My name is Paul Diggle, Chief Economist at abrdn.

 

Luke Bartholomew

And I'm Luke Bartholomew, Senior Economist at abrdn.

 

Paul Diggle

And today we are talking about interest rates and bond yields. So, the sell-off in global government bond markets has gathered pace over recent months, US 10-year Treasury yields crossed 5% at one point, but what has been driving this and what does it mean for central banks and the economy? So, we're joined by abrdn’s Deputy Chief Economist and US macro expert, James McCann, to talk about all this. Welcome James.

 

James McCann

Thank you for having me.

 

Paul Diggle

So let's start with a bit of market context, then James. So what have bond yields done over the past few months? What have curves done? Equities? The dollar? Why don't you lay out the market background here?

 

James McCann

Absolutely. Let's start there. And I think it may be useful to talk about that 10-year US Treasury Paul, which really forms the bedrock of the US financial system, and arguably the bedrock of the global financial system too. If we cast our minds back to the summer effectively, that was bumping around or running around a rate of 3.75%. And that already represented quite a significant adjustment over recent years as the interest rate structure had adjusted, following the post-pandemic acceleration in inflation. And as you mentioned, we had seen that 10-year rate over recent sessions spike to above 5%. It’s trading a little bit below there now, but certainly quite a significant sell-off in the 10-year Treasury over recent weeks and months. We've seen some adjustments in the shorter end of the yield curve too but by notably less. And that means that if we think about the yield curve, which is essentially the difference between short-term and long-term borrowing costs, back in the summer that had been showing short-term rates relatively high, and that reflects the high Federal Funds rate at present, and the expectation that the Fed would need to keep that high over the next few months and years, maybe, to eke inflation out of the system, but in an expectation that interest rates would fall away further forward as some form of rate normalisation kicked in. Now that yield curve is showing a flatter profile for interest rates. So essentially, what we've got embedded in the US yield curve is a rate structure that shows interest rates higher for longer. And that dynamic has been quite a painful one to absorb for markets. So if we look at credit spreads, you know, the additional costs that companies pay on their debt issuance, you know, for the best quality companies - investment grade - those spreads have risen by around 20 basis points or so. Tat's on top of the existing increase in US government bond rates. For the riskier companies - high yield companies - they're being charged an extra 80 basis points. Again, that's on top of that rise in the US Treasury rate. So, you know, all in all, close to a 200 basis point increase in borrowing costs. You know, through that period, equities have fallen by around 10% or so, the US dollar is up around 4%. If we aggregate these signals, we can do that through things called financial conditions indices, which look across a wide range of financial market signals, we see that they're close to their peak that they increased to in late 2022. And our financial stress index, which again tries to incorporate aspects of stress seeping through the financial system has started to spike again. So it's been quite a traumatic dynamic to absorb into markets. And certainly we're seeing it ripple through all associated prices.

 

Paul Diggle

I want to introduce here a crucial decomposition of bond yields, which is essentially made up of two components, expectations about future policy interest rates over both cyclical but also long-term structural horizons. We've done previous podcast talking about R star, where policy rates may head into the long-term. So that's one component of what drives bond yields. But there's this other second component which is the term premia. It’s the residual. The part of a bond yield that can't be explained by policy interest rate expectations. Its generally thought of as compensating investors for holding bonds, particularly long-dated bonds, as opposed to holding, say a series of short-dated bonds. Its the risk premia or compensation for bond risks that investors demand. And this distinction is important because the latest leg of the Treasury market sell-off that you were describing James over the past couple of months, that had been primarily driven by changes to the term premia, as opposed to the sell-off earlier in the summer which was driven by changing expectations of central bank policy path and higher for longer. And this technical, possibly a little bit esoteric distinction, it matters because then it helps us think clearly about the drivers of the bond market sell off, and how the Fed and other central banks will ultimately think about it.

 

Luke Bartholomew

And it's worth saying Paul that, at least for some market analysts, the idea of the term primia is something that they're quite sceptical of as an analytical category. It's not the kind of thing that can be directly observed in the way that you defined it there. There's this sense of there's almost a definition by residual, which in other contexts, we sometimes refer to as the ‘measure of our ignorance’ as much as anything else. And it does often depend on the particular modelling strategies that you use, and the way in which you try to back out expectations or where policy rates will go to. Those kinds of assumptions are critical to forming a view on how the term premium has moved. But I think that kind of scepticism can be overdone, because there are things that you can reasonably think of as affecting the price of bonds, or the yield on bonds, that don't necessarily work through at least in first-order expectations of policy interest rates. And the kind of things I'm thinking of would be, for example - one, just the uncertainty around that policy path. It makes sense that if this is the compensation that investors demand to hold a long-term bond rather than a series of short-term bonds, well, perhaps if they're more uncertain as to how interest rates will go over that long period, they’ll demand more compensation for that. And I think the ongoing debates that we've been having on this podcast and market participants are having everywhere about the outlook for the US economy, whether there's going to be a hard landing, soft landing, mild recession, whatever it might be, that kind of debate is reflective of the degree of uncertainty at the moment that it does seem unusually high. Another factor would be things like government issuance of bonds. And you know, there are issues with using very simplistic demand and supply diagrams in this way when thinking about bond prices. But essentially, you can think of government issuance as supply of bonds to the market and all else equal, we tend to think of increased supply, pushing down on price and therefore up on yields in this context. Now, government issuance wasn't a particularly big deal in the period after the financial crisis, well, because demand for government bonds was also very high as well, in part, because there was this sense that there was a scarcity of risk-free assets. And so high demand for bonds against that high supply meant the term premium could keep relatively low. But without that demand for safe assets, then supply from governments becomes more important. And then the other big source of demand, of course, was central banks buying these bonds through quantitative easing. And that is also something that's changed as well with central banks now, in fact, selling bonds from their balance sheet through the process of quantitative tightening. Now, typically, we tend to emphasise more the impact of QE through other channels. But I do think that does have an important effect on the margin that they are this price-insensitive buyer. And if they're no longer there, then presumably that is less demand - and all else equal - prices should be lower. The fourth thing to think about would be, and this is a little bit more esoteric, but the likelihood of the economy hitting the effective lower bound in interest rates. And so as interest rates have increased over the last couple of years, then perhaps the likelihood of interest rates hitting zero again, when a shock comes along, has also decreased. And it's precisely when interest rates are at the lower bound that you get quantitative easing. So to the extent to which QE has pushed down on yields, the fact that it's becoming less likely because the lower bound is less likely, that should also push up on the term premium. And finally, also quite esoterically. There's this idea that bonds are perhaps becoming a less good diversifier in a portfolio of equities just because of the changing structure of the economy and the kind of shocks it's going to face.

 

Paul Diggle

So, a lot of explanations there, Luke, of why term premia could be rising. Let's dive into a couple of them in a bit more detail in particular James, just how big is the US fiscal deficit? Why has it been so large? And what are the problems macroeconomically, and politically, with having a very large US fiscal deficit?

 

James McCann

The deficit is unusually large, especially for this stage of the cycle. So we try and adjust. There have been one or two funnies going on with student debt relief which have distorted some of the headlines. If we take those into account, our best calculation is the US was running a deficit of around seven and a half per cent of GDP in fiscal year 2023. That represents a pretty significant widening from 2022. Driving that seems to be, you know, a particularly sharp and unusual drop in receipts. That could be because 2022 receipts were really high as people booked capital gains on a whole bunch of assets following the post-pandemic, you know, appreciation and strong asset market performance. It also could be reflecting some of the timings around tax payments. So there are late payments coming in in some states. So, it's possible that, you know, that deficit of seven and a half per cent slightly overstates where the underlying deficit is, but still, it's pretty concerning, especially given that we're in an economy pretty close to what we would consider at full employment. And it speaks to there being a permanent hole in the US public finances where revenues and receipts just won't match. You know, we call that a structural deficit. And it's something that sits there regardless of the position of the business cycle. The IMF’s current estimate for the US structural deficit is actually larger, at close to eight to nine per cent of GDP. And the worrying thing, I guess, for the US is, we are in relatively good times, at the moment, at least with regards to the strength of the economy in the short-term and the labour market dynamic. Should the US go into recession, let's imagine next year as we're currently forecasting, and as the automatic stabilisers kick in, that deficit would naturally widen. And so, I guess the market could be looking at this dynamic and saying, it's not impossible if the US comes off the rails that that deficit really spikes quite significantly. And then the second issue is the US has a lot of existing debt, and it's having to refinance that a higher prevailing interest rates. You know, the average maturity of the US Treasury market’s not that long. It's about six years. That compares to 14 in the UK. And that means the US Treasury having to come back more frequently to refinance and it's doing so now at painfully high interest rates. So when we look at just the interest costs on financing the US current deficit, it's possible that they spike to around three and a half per cent of GDP next year. So that's a pretty decent component, probably, of that structural deficit story and one that's probably getting worse too. So this is not to be super alarmist and say, oh the US is under threat from bond vigilantes, and we'll see, you know, ever rising US interest rates as people question debt sustainability, but it's certainly the case of the US issuance schedule, they're going to have to issue a lot of paper over coming years. And, you know, when markets look at that, and maybe the lack of a credible fiscal plan, you know, dysfunction on Capitol Hill, you know, perhaps some of the appetite to take that is slightly less willing. So, you know, maybe that's one of the dynamics, which is, which is factoring in here, as Luke said, probably a few things going on. But certainly that's not a helpful backdrop for fixed income markets.

 

Paul Diggle

Yeah, that's a very good point, you make James. It’s not default risk, per se, that investors are worrying about in the US, but it's anything other than a technical default that could accompany a debt ceiling standoff, but it's worries about the size of issuance, the potential inflationary consequences as well of running large deficits at a time of being at or beyond full employment. Luke, why don't we expand on one of the other drivers of higher term premia, lower bond prices that you laid out there, which is the balance of demand and supply shocks hitting the economy. Why would more supply shocks mean higher term premia? And why do we think that balance of shocks is shifting?

 

Luke Bartholomew

Sure, so the idea is, in a standard way of thinking about how you construct a portfolio, bonds and equities are natural complements to each other, because when equities do well, bonds tend to do poorly, and vice versa. And that's a very nice property for a diversified portfolio. And the reason people think about them working in that way is that when the economy is hit, by a demand shock, it tends to push growth and inflation in the same direction. So a positive demand shock pushes up on growth and higher growth against capacity constraints tends to push up on inflation. And so in that case, the stronger growth tends to help equities, but at the same time, the stronger inflation also tends to mean that interest rates go up. And that's bad for bonds. So they're moving in opposite directions. And then the logic runs in reverse with a negative demand shock. So it's bad for growth, and that's bad for equities, but at the same time, inflation is falling and so interest rates tend to fall and so the bond part of your portfolio performs very well. The problem is in a supply shock driven environment, growth and inflation move in opposite direction. So a positive supply shock pushes up on growth, but also down on inflation because there's more capacity to take that stronger growth. And that means that you then don't get this nice correlation structure between bonds and equities, because in this environment at the negative supply side shocks that we're seeing at the moment in particular, you get poor growth, but you also get high inflation, which pushes interest rates up. So your equities perform poorly because of the poor growth, but your bonds perform poorly as well, because of the higher inflation, meaning interest rates go up and therefore prices down as you say Paul. And so supply side shocks do not bring out that nice diversification quality within a portfolio. So in a world where you tend to be only getting or it's dominated by demand shocks, that diversification works very well. And I think that broadly, describes the environment during the so-called Great Moderation from maybe the 90s, including, to some extent, the post-financial crisis period, as well. But since the pandemic it does feel like we're moving into a world where the so-called data-generating processes is one which is churning out more supply side shocks, and in particular, more negative supply-side shocks. So one thinks of things like well, the pandemic itself, but also geopolitical uncertainty, the sense of a rising global polarisation, and also climate change, as well. All of these things you would tend to think would lead to a world that is more characterised by supply-side shocks and negative supply-side shocks at that. And therefore you don't get that portfolio diversification benefit from holding bonds, and that therefore makes them less attractive to investors. So all else equal, they'll pay less for them, which is another way of saying the term premia should be higher.

 

Paul Diggle

And then this deep dive on term premia. This matters because the drivers of term premia as opposed to the drivers of higher policy interest rates are different and may persist or fade over time, in different ways. So we did a previous episode on the equilibrium real policy interest rate, and explained why that is high right now in a post-pandemic environment. But we think there are good reasons to think that the long-term equilibrium policy rate is still fairly low. The next big moves in central bank rates is probably downwards. On the other hand, these drivers have higher term premia, deficits and issuance, as James has been talking about, the balance of demand and supply shocks, as you mentioned there, Luke, there could well be reasons to think that those actually are very persistent. And we could be in a higher for longer world vis a vis term premia, even though we aren't necessarily in that world for policy interest rates. James, how does the Fed think about all this? We've had some messaging from Fed officials about the exogenous tightening in financial conditions represented by higher term premia. How's that playing into their thinking and policy rate decisions?

 

James McCann

I mean, this is very important for the Fed, they're watching it very closely. And I think we've had, you know, a whole host of Fed speakers come out and say very explicitly that they're factoring this into their decision-making. And I think that dynamic between the rise in interest rates, which is driven by term premia versus a rising interest rate, which is driven by changing fundamentals be it around the neutral rate, or around inflation outlook, etc. I think that's a really important dynamic that they're following. Certainly, if the rate structure is increasing because people are becoming more optimistic on the long-term growth or long-term inflation or the long-term interest rate outlook, then I think that's something that the Fed could absorb. And maybe it wouldn't change its underlying policy dynamics as concretely. But if it's a rise in interest rates driven by some market technicalities around these term premia be it the issuance schedule, be it changing correlations between different asset class returns, be it just fundamental uncertainty over the interest rate outlook, then I think they see that as an effective tightening in policy which isn't warranted by the domestic fundamentals. And so it's one that they need to take carefully into account when they set their own policy. And actually, the message coming from from Chair Powell and a whole host of Fed speakers, has been that, you know, this adjustment really has done a bunch of the work for us. I think, you know, certainly the Fed was signalling that they would hike once more this year. I think that was likely to be a pretty close call. I think seeing the adjustment in market interest rates and obviously the tightening of policy that that generates, and the nature of that tightening in policy. The message we're getting at the moment is that's enough, we'll take that tightening in policy and we'll bank it and say that's efficient for the time being.

 

Luke Bartholomew

So then, finally, James, on this idea of doing some of the work for us, I mean, how much of an impact should we think that this tightening in financial conditions is going to have on the US economy? And in particular, one distinction that I'm interested in, is the standard ways in which tighter financial conditions, higher interest rates, affect interest rate-sensitive sectors of the economy, and then separate to that, the impact on financial stress. So the idea that maybe there are some breaking points or some nonlinearities in a very rapid rise in interest rates or interest rates rising beyond a critical point, that causes some sort of breaking, exposures of vulnerability, arguably, that was the case with the banking sector issues earlier this year. So just in terms of those two impacts, how do we think about the way in which this is weighing on US growth?

 

James McCann

I think that's a neat way to separate it and come at this question. Absolutely. If we take the first aspect, just that, you know, almost vanilla-ish tightening in longer-term interest rates – that’s an effective tightening of policy tightening in the cost availability of money. There are a whole bunch of ways that we can think about this or model this. The Fed itself has its own financial conditions index, which then it maps onto growth implications. And given that financial conditions tightened to similar rates, to similar levels, as we saw late last year, you know, back then the Fed’s models were telling us that that was consistent with a drag of around one to two percentage points of GDP over a one-year horizon. So it's very clear that the financial conditions at these levels will feed into the economy, probably show up first in the interest rate-sensitive sectors, Certainly the housing market looks under pressure, again, from an eight percent mortgage rate. Aspects of that market remain frozen as anyone who's fixed is just completely refusing to move on to those prohibitive rates. We think it'll show up in aspects of capital spending. We know that new issuance has been very weak by corporates on the debt side, We know that CNI lending has been very very weak. We probably expect that to continue to show up as well, or perhaps show up more on household balance sheets. We're seeing household interest payments as a share of income rise quite quickly now. And they're above where they were in late 2019, as well. So, you know, these classic monetary transmission mechanisms are coming through the economy and the adjustment in the entire rate structure should amplify them. You know, I think that the points around financial stress, we have our own financial stress index that’s started to spike again. We tend to find that you know, hits growth through those same financial conditions channels, as we've just discussed in the Fed modelling work. In terms of cracking points, they can be hard to spot ahead of times. It's actually one of the questions that we discussed with our US equity and credit colleagues at a recent get together where we got into this issue. And I think it's important to monitor the banking system very closely. We know that aspects of deposit flight in this high-interest rate environment, banks holding fixed income securities, which, you know, have potentially large losses on them, that can be quite a toxic combination. So certainly watching individual banks that might be exposed through some of those channels, in terms of broader you know, outside of that regional banking complex that flared up back in March, you're looking closely at those who might be holding fixed income portfolios, so life insurance sectors, for instance - while under scrutiny, not seeing systemic issues. And companies as well, having to refinance onto much higher interest rates, are obviously under close scrutiny. For our credit, our credit colleagues, you know, some of the step-ups from those rates that you were able to achieve in 2020/21 are really significant. And, you know, with profit growth starting to decline, it's possible that  actually it becomes increasingly difficult to afford that debt. Again, we're not seeing signs of, of systemic stress there, but certainly want to be careful and, you know, be watching individual companies quite closely. So, you know, at the moment not seeing signs of a systemic crack, but I think monitoring with  you know, real caution, given the scale and the speed of the increase in market rates and the risk potentially that, you know, we're not at the end of it.

 

Luke Bartholomew

It might also be worth adding that whilst our conversation has, of course, focused on the US that this financial stress is also cropping up internationally, as well. So the rising bond yields globally have been putting pressure on the likes of the Bank of Japan and its yield curve control policy where higher interest rates globally tends to push up those Japanese bond yields and the Bank of Japan is finding itself gradually having to step away from yield curve control policy – otherwise it's putting huge amounts of downward pressure on the yen. And similarly in the Eurozone, higher interest rates are pushing up the financing costs of the likes of Italian government debt. And the European Central Bank finds itself in a relatively difficult position handling issues like that. Partly because it, you know, it has its own inflation issues that it wants to keep monetary policy tight for, but also, it's difficult for it to be seen to be involved in financing of government deficit, particularly in countries where there are some questions about the way in which budgetary policies are being managed. But anyway, that is probably all that we have time for this week. So as ever, please do let me ask you to subscribe and review us on your podcast platform of choice. And then all that remains is for me to thank James for joining us today and his excellent insights and to thank you all for listening. So thanks very much and speak again soon.

 

 

This podcast is provided for general information only and assumes a certain level of knowledge of financial markets. It is provided for information purposes only and should not be considered as an offer investment, recommendation, or solicitation to deal in any of the investments or products mentioned herein and does not constitute investment research. The views in this podcast are those of the contributors at the time of publication and do not necessarily reflect those of abrdn. The value of investments and the income from them can go down as well as up and investors may get back less than the amount invested. Past performance is not a guide to future returns, return projections or estimates and provides no guarantee of future results.