Academics and policy makers have spent decades trying to prove that rising deficits increase bond yields, and publishing a flood of articles that purportedly prove this connection. However, no competent person takes these papers seriously. This article explains why these articles are largely doomed, and are primarily exercises in how to understand that academics have tried to lie with the help of statistics.
If the proof existed, you will hear about it
If a robust econometric study linking budget deficits to bond yields, you’ll hear about it. The reality is that it is not. Instead, you hear people discussing obscure documents where academics have proven something or other. Either way, the textual claims in the abstract fall apart once you look at the actual mathematical methodology.
The econometric problem is extremely difficult
It is difficult to link deficits to bond yields. A number of factors explain this.
- If we go back in time, data on bond yields prior to 1980 or even 1990 is not comparable to the current environment. Currencies were indexed and / or interest rate regulations existed. For example, the rate hikes deployed by the Bank of England to defend the pound during the ERM debacle are not a typical feature of sovereign floating-currency interest rates.
- Even when we have floating currencies, the number of “independent” observations is not particularly large. Once the ERM fiasco was settled, developed countries largely synchronized interest rate cycles. The biggest outlier – Japan – blows up any theory that links debt / deficits to bond yields, so our intrepid academics either ignore Japan or add epicycles to their theories to explain it. The other set of outliers were the “flat-line” countries, primarily the UK and Australia. These countries have hyperactive housing markets, where financing tends to be variable rate. As such, there was sensitivity to the policy rate and the curves remained flat.
- In countries with cycles and steep curves (United States, Canada), the yield curve and deficits are cyclical. The level of interest rates fall during recessions – exactly when the deficits are greatest. Since this is the “wrong” answer, academics are starting to pretend that they can compensate for the effect of the cycle.
The extent to which “supply and demand” appears in yield curves is usually in the form of pressure on long-dated bonds. The UK Curve has been a horror spectacle of relative value since the mid-1990s, thanks to pension regulations. Meanwhile, the market is tightly owned by the big players, and they tend to squeeze relative value foreign investors who move into their territory. (The same is happening in Canada.) The other example is the ability of central banks to squeeze the long end during massive QE expansions of their balance sheets. If the central bank buys back all the bonds, there isn’t much market left to look for fair value.
However, in both cases the problem is that the long-term returns are too low, which is not the preconceived answer academics and policy makers want to see. They want higher returns.
Why don’t we see bond yields skyrocketing to the moon on supply? Institutions.
Every developed country has the equivalent of the UK Debt Management Office. They have long, boring discussions with the long side and the short side to see what maturity structure investors are interested in. They only issue long-term debt if there is a proven demand. If they did something stupid and gave up billions of debt over 50 years that could not be absorbed onto the market, these bureaucrats would be looking for new jobs. So we don’t see that happening.
Rather, short-term maturities are used to deal with fluctuations in the budget balance. Only the most delusional investors disagree with the idea that short-term debt is in line with rate expectations.
If researchers spend decades looking for something and can’t find it, the best thing to do is ask why it is. In the case of the link between deficits and bond yields, even a tiny knowledge of bond issuance practices offers the explanation.
(c) Brian Romanchuk 2020