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HomeboeRe-emerging Risk Premium in Bonds Threatens Central Bank Control of Credit

Re-emerging Risk Premium in Bonds Threatens Central Bank Control of Credit

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Bond borrowing rates have recently spiked, causing concern among U.S. Federal Reserve officials. Despite unchanged Fed policy expectations, a resurfacing “term premium” demanded to buy and hold longer-term bonds is responsible for the spike. This phenomenon could complicate the central bank’s policy transmission to the wider economy.

The spike in borrowing rates is likely due to nervousness surrounding rising public deficits, debts, and bond sales. Central banks may have to publicly warn their political masters about the risks associated with these mounting fiscal concerns. Last year, the Bank of England was forced to react to Britain’s brief budget and debt shock, which serves as a preview of the challenges central banks may face.

Olivier Blanchard, former chief economist at the International Monetary Fund, believes that the sustainability of government debt is at the heart of the issue. He highlights the question of whether interest costs on the debt exceed economic growth projections. Blanchard warns that if long-term rates do not decrease or primary budget deficits are not brought to zero, rising debt levels as a share of gross domestic product are “inevitable” and could potentially “explode.”

However, the situation is more complex than simple arithmetic. Fiscal inertia in the United States and Europe does not inspire optimism for tighter budgets, and hopes of interest rates decreasing are likely in vain as long as inflation remains above targets. A durable rise in bond term premiums based on fear of fiscal concerns may cut across optimism for policy easing.

Blanchard suggests that major economies should start reducing primary deficits toward zero to sustain debt ratios at higher but stabilizing levels. He also notes that higher long-term rates may lead to lower short-term rates to partially offset the impact. While the situation is not catastrophic, doing nothing poses a risk of the feared debt explosion.

The Congressional Budget Office’s projections estimate that U.S. debt-to-GDP will nearly double to 180% by 2053. These projections were made before the recent bond yield spike. Currently, 10-year yields have already risen to 4.5%, and the average rate on all Treasury borrowing has exceeded 3%.

Despite accelerated U.S. growth in the last quarter, full-year real GDP growth is expected to be just 2.1% this year and 1.5% in 2024, according to IMF forecasts from last month. These figures are well below the average interest rate on Federal debt and the current 10-year yield, which raises concerns among investors.

The Federal Reserve may not have full control over the situation. If it remains determined to stick to its rate policies until fully quashing inflation and reducing its balance sheet, it may need to apply public pressure on fiscal policy. However, this could be a tricky proposition in an election year.

Bond investors are looking for signs of relief. Some believe that the Fed is done tightening, and U.S. fiscal expansion has peaked for now. Morgan Stanley suggests that there is little reason to expect significant fiscal legislation before the 2024 election. Consequently, 2024 is seen as a pivotal year, and monetary policy is no longer the sole focus.

In conclusion, the recent spike in bond borrowing rates has raised concerns among central banks, particularly the U.S. Federal Reserve. The spike is likely driven by nervousness surrounding rising public deficits and debts. If these concerns continue to mount, it could complicate the central bank’s ability to control credit and transmit policy to the wider economy. The sustainability of government debt is a significant factor in this issue. Economists warn that without reducing primary budget deficits or decreasing long-term rates, debt levels could increase and potentially “explode.” While the situation is complex, central banks may need to publicly warn their political masters about the risks associated with mounting fiscal concerns.

More detail via Investing.com here… ( a )

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