We are all ‘in hock to the bond market’

I honestly get really aggravated when I hear politicians on the left of the political spectrum argue that we should stop paying attention to bond markets and rather spend more to help people. This seems to be a particular affliction of left-wing politicians in the UK, so much so that the New York Times felt obliged to explain this to its US readers.

I have previously written about a study that showed how the UK is now treated like Italy thanks to one previous Prime Minister deciding to engage on a path of unfunded deficit spending (ironically, that one was a politician on the right, proving once more that neither side of the aisle has a monopoly on economic illiteracy).

Responsible politicians should know how much their spending influences the bond market and thus the interest a country has to pay to finance its deficit. While I don’t know of a recent study that estimates the link between UK budget deficits and Gilt yields, I came across a study by the Federal Reserve Board focusing on the US.

They found that if the US debt/GDP-ratio is expected to increase by one percentage point (not an actual increase, market consensus estimates are enough), the expected 10-year Treasury yield five years in the future rises by about 4 basis points. To put that into perspective, if the refinancing costs for the US Treasury rise by 4 basis points across the board, this would, in the long run, increase interest payments by $14bn.

But it’s not going to be an even increase in borrowing costs across the board. Rather, the term premium for long-term Treasuries rises by about 2 basis points, and the risk-free rate picks up by another 2 basis points.

Impact of a 1ppt increase in debt/GDP on 5-year ahead US Treasury yields

I have written before how there is more and more evidence that bond investors are asking for a rising risk premium on bonds from heavily indebted countries. The US may have the extraordinary privilege of issuing the world’s reserve currency, which insulates it to a large extent from these effects, but even there, the Treasury recently found itself in a situation where it had to admit indirectly that long-term Treasury yields are too high, so it refinanced maturing debt at shorter and shorter maturities to keep costs low.

Now, where have I heard that before? Ah yes, Greece in 2011…