US bond yields receive a boost from fiscal policy

Posted on November 25, 2016

The sharp rise in yields on sovereign debt this month might lead some investors to conclude that the long bull run in global bond markets is over. US Treasury yields have increased by about half a percentage point, exerting a gravitational pull even on German and Japanese debt. Any trader with a long memory will be thinking of great wipeouts like that of 1994, when government bond prices across the world fell together, hammering investors.

Yet the divergence of sovereign yields is as striking as the overall direction. The spread between German 10-year bond yields and those of France and Italy has widened, reflecting concerns over political instability. In Britain, the increase in yields this month has been more muted than in the US, especially for shorter-dated debt, reflecting expectations of US interest rates rising sooner than in the UK.

In the US and the UK, political change has brought the possibility of a significant loosening in fiscal policy. Such a stimulus would be welcome, if done in a way that delivered a swift boost to demand. The question is whether the measures under discussion will achieve this.

The movement in US Treasury yields directly followed the election of Donald Trump, who had promised big tax cuts and hefty increases in infrastructure spending. In the UK, the replacement of David Cameron by Theresa May as prime minister, and George Osborne by Philip Hammond as chancellor of the exchequer, has given the government an excuse to tear up Mr Osborne’s fiscal rules and distance itself from his association with austerity.

Mr Hammond, in this week’s Autumn Statement, gave himself considerably more wiggle room by adopting new fiscal rules that could be met by getting public finances back into surplus as far away as 2025. He has also decided to borrow an additional £23bn to fund new infrastructure investment. However, there was no suggestion that fiscal stimulus would be used to complement monetary policy in guiding the economy. Yields on government gilts rose somewhat but traders said that reflected the need to borrow more because of a slowing economy.

In the US, by contrast, investors have apparently bought the idea that a big boost is on the way. Whether this belief will endure is another matter. Upon closer examination, Mr Trump’s plans seem to rest largely on a proposal to give tax breaks to companies for infrastructure investment. But given that many of those plans might have gone ahead anyway, the scheme may end up simply handing money to corporations that are in no need of subsidy, without increasing capital spending. Similarly, his planned tax cuts are largely destined for rich households liable to save rather than spend their windfall.

This would still lead to a big increase in US government debt. In this context, a permanent rise in global borrowing costs from their recent historic lows is plausible. Yet if Mr Trump’s fiscal easing does not, in the end, do much to boost aggregate demand, US Treasury yields could fall back. Similarly, if the UK Treasury decides to let spending rip to combat a downturn in the UK economy, it will weigh on gilt prices, particularly at a time when a weaker pound is fuelling inflation.

The return of fiscal policy to centre stage is welcome. It is time for governments to share the burden of raising global growth with overworked central banks. But whether investors are right to bet on higher growth and inflation will depend on how any stimulus is designed and whether it genuinely boosts demand. When it comes to Mr Trump’s policies in particular, that remains an open question.

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