Surging bond yields and fiscal crisis remain unlikely

Abstract

▀ We expect core government bond yields to trend upwards over the next five years, but based on our modelling work, a big surge in yields looks unlikely. Even our most downbeat scenario implies only moderate rises in debt service costs, suggesting governments will be relaxed about rising yields. ▀ Core government bond yields have been low for over a decade, helped by excess global demand for certain government bonds seen as “safe assets.” But there are historical examples of yields surging after long periods during which they've been low and steady, such as in the US in the 1960s‐1970s. ▀ We ran a series of model scenarios that simulate the impact of factors such as a sharp rise in government debt, curtailed QE, reduced demand for core currencies as FX reserves, and higher inflation. Individual shocks to supply and demand for these safe assets add an extra 14bps‐70bps to yields. A combined shock adds an extra 130bps to US 10‐year yields by 2025, going to 3.5% from our baseline of 2.2% and 0.9% currently. ▀ The rises in yields generated in our scenarios look small by historical standards, although they would imply quite large price changes in bonds given the low starting level of yields. Some of the individual shocks could result in investors suffering losses similar to those in 1994 or 2013–2014. In the combined negative scenario, losses could approach those seen in 1965–1970. ▀ Rising bond yields feed into higher government debt service costs only gradually, especially when average debt maturity is long. As a result, most governments are likely to be quite relaxed about rising yields, and these should not be a big barrier to continued loose fiscal settings. Investors cannot rely on the reimposition of austerity to help limit their downside this time around.