Budget Deficits and Bond Yields

Questions on budget deficits and bond yields.

1. What is the Link between the size of a countries budget deficit, and bond yields?

deficit

Highest budget deficits – Ireland, Japan, UK and US

10 Year Bond Yields

bond-yields

 

  • Greece and Ireland seem to have the relationship you might expect – deficit close to 10% of GDP causing bond yields to rise.
  • But, in the case of Spain and Portugal, bond yields are high given their relatively modest budget deficit.
  • By contrast, UK, US and Japan have very high budget deficits – yet they have very low bond yields.

Firstly, as well as looking at annual budget deficit, it is important to also consider total levels of debt. For example,a budget deficit is more of a problem if your debt to GDP ratio is already over 100% of GDP. But, on this count, UK, US and Japan have a public sector debt higher than Portugal and Spain.

Why are bond yields so high for Spain and Portugal, but so low for UK, US and Japan?

Itamar Caspi offered this explanation:

1. Independent central bank – If a country has it’s own currency, the link between the size of the deficit and bond yields will probably be weak (see the US UK and Japan). On the contrary, being unable to run independent monetary policy will lead to a positive relation – higher deficits lead to high yields.

2. Fiscal multipliers – The larger the effect of contraction fiscal policy (deficit reduction) higher is the probability that cutting the deficit will lead to slow growth and thus to higher yields. That is why we see yields rising even though a country follows fiscal consolidation. for small multipliers, the effect will be the opposite – cutting the deficit will lead to lower yields (for more on that – view IMF – Too much of a good thing).

That is a good start. In addition, I would add.

  • Why an independent Central bank helps keep bonds low.- The Central Bank can create money and buy bonds. This helps avoid liquidity shortages. Markets have more confidence their will not be a liquidity crisis.
  • Exchange Rate Policy. Southern European countries are suffering from uncompetitiveness. Their exchange rates are relatively overvalued leading to lower export demand. This overvaluation in exchange rate is another factor leading to lower economic growth.

Overall, I would say the adverse prospects for growth in southern Europe are one of main reasons for rising bond yields. If nominal GDP is predicted to fall, debt to GDP ratios are highly likely to increase.

Related

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3 thoughts on “Budget Deficits and Bond Yields

  1. 1. Bond yields essentially reflect the market’s perception of the ability of a government to pay back it’s debt. The lower the yield, the more confident that investors feel about the ability of the debtor to repay the debt. Therefore, they have no directly proportional relationship with the size of the government’s budget deficit. However, if investors feel that for a particular government, the excessive size of their debt will lead to unsustainable debt servicing costs, they may be less inclined to supply the government with debt, thus raising bond yields.

    2. The New York University states that the EU’s long term goals to reduce unemployment are:
    a) Higher Employment Participation — Because of the aging of its population and the threat to pension systems, Europe needs to have a higher proportion of its working-age population working. This means early retirement should be discouraged. More women will and must work. More part-time employment must be encouraged.

    b) More Active Unemployment Systems — Passive unemployment systems allow skills to deteriorate, fail to encourage workers to actively seek work, and don’t supply the skills the workers need to find work.

    c) More Skills — The increase in technological change means that workers need more skills at the outset and need to be able to develop new skills throughout life.

    d) More Employment Intensive Growth — Europe lags behind in the provision of services, which provide employment intensive growth. This is especially true in the “social economy” including services provided by non-profit groups and private companies. Europe must encourage the social economy and decrease direct taxes on labor-intensive services.

    e) Fewer Obstacles to Low Skill Work — Europe must move towards more high skill jobs but low skill workers can’t be left behind. Tax systems, especially high, flat-rate social charges discourage low skill workers from working and impede more hiring of low-skill workers. Tax systems need to be adjusted to make work pay. Energy taxes provide one option for replacing lost revenue.

    f) Flexibility with Security — Technological change and changes in the nature of markets requires more flexibility in the way work is organized and workers organize their lives. The model of a male worker working full-time on a normal work week for one company his entire life must be replaced by a model that allows companies more flexibility in terms of working time, envisions greater heterogeneity in the types of workers (men, women, full-time, part-time), and supports workers who will shift companies and careers much more often. This new flexibility must be fostered while providing new mechanisms for providing security to workers.

    g) Smaller Companies and Entrepreneurship — The most dynamic areas of the economy are small and medium-sized enterprises. To get more innovation, Europe needs more entrepreneurial companies. The European Social Model needs to be adjusted to encourage such firms which are often smaller and more dynamic than the traditional firms for which the Model was originally designed.. One partial solution is for tax systems to be reformed to make self-employment and the setting up of small businesses more desirable.

    h) Gender Equality — Women face particular disadvantages in the labor market. These include such things as pay discrimination, higher levels of unemployment, and obstacles to combining work and family life. In order to increase employment participation by women and provide equal opportunity, these disadvantages must be addressed.

    However, in the short term, the EU has not implemented substantial micro-economic reforms that target the reduction of unemployment, especially in the regions such as Spain and Greece which face austerity measures rather than effective government support of industry.

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