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A bond 'doom loop' should mean that yields rise with more borrowing — but history says the opposite

US Capitol building in Washington, DC.
US Capitol building in Washington, DC.Getty Images
  • High government borrowing is usually associated with lower bond yields, Matt King wrote in the Financial Times.

  • That's the case for advanced economies most of the time, going back to the 1880s, he added.

  • This record is counterintuitive to assumptions that bigger deficits force governments to raise rates to attract investors.

Rising alarm that Treasury yields will spiral higher amid deteriorating fiscal conditions won't find much backing in history, Matt King wrote in the Financial Times.

Instead, higher borrowing levels in developed economies have almost always been associated with lower bond yields, according to the Satori Insights founder.

"This finding is not confined to the US: it holds in Germany, Italy, Japan, the UK, Switzerland and Australia back to the 1880s," wrote King, who is also a former global markets strategist at Citigroup.

It also applies to overall debt levels as well as fiscal deficits, which he called "deeply counterintuitive."

That goes against a growing consensus that current highs in US borrowing will drive bond yields up, assuming the government will need to lure wary investors with bigger returns.

Alarms about this "doom loop" scenario have been raised by market heavy hitters, such as Ray Dalio and Bill Gross. If left unchecked, the phenomenon could eventually help spur some form of default within two decades, a Penn Wharton Budget Model previously noted.

King offered three reasons why bond yields have fallen during borrowing binges and why the current surge will play out similarly.

One is that government intervention has ofter been employed to hold down yields. This includes an expansion in central bank balance sheets, accounting regulations, and capital controls.

Another is that economic strength and expectations of where rates are headed are the key drivers of bond yields, not deficits.

This outlook was recently echoed by Treasury Secretary Janet Yellen, who said in late October that confidence in the US economy was behind the rise in yields, as well as expectations of a higher-for-longer monetary environment.

And finally, the borrowing process is more self-funded than realized. For example, issuing a bond doesn't actually draw down private-sector liquidity on net: the proceeds are instead invested into the real economy by governments, eventually flowing back into bank deposits.

"Stranger still is the impact on broad money, or credit. When an actor levers up, the system as a whole gains assets as well as liabilities," King explained. "The process of borrowing therefore itself creates 'money,' at least in the broad sense of total credit, from nothing."

That's why aggregate borrowing levels correlate more closely with asset prices than with bond yields, he added.

To be sure, this dynamic doesn't justify unlimited deficit spending, King cautioned, pointing to last year's spike in UK bond yields after then-Prime Minister Liz Truss's government proposed a budget that called for tax cuts and more borrowing.

"But just as increases in corporate defaults tend to be sparked less by looming debt maturities and more by collapses in earnings, so fiscal crises in bond markets tend to be driven less by the inevitability of compounding interest payments and more by sudden collapses in credibility, currency runs and imported inflation," he said.

Read the original article on Business Insider

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