Latest / Radio Davos / Chief Economists Outlook: what bond yields and interest rates tell us about the global economy
Transcript
- 0:02The global economy has been affected by several negative supply shocks.
- 0:05Tensions in the Middle East.
- 0:07Tensions in Ukraine, a renewed rise in tariffs that the U.S. has imposed
- 0:11on some trading partners.
- 0:12All of those are leading to a higher interest rate environment
- 0:16because they're crystallising into higher inflation.
- 0:19Welcome to Radio Davos, a podcast from the World Economic Forum
- 0:22that looks at the biggest challenges and how we might solve them.
- 0:25This week we're talking about the global economy
- 0:27as the Forum publishes its latest Chief Economists Outlook.
- 0:30One chief economist tells us where we should be paying attention.
- 0:33Why, for example, are we hearing so much about rising bond yields?
- 0:37I think there are a few factors that are behind this upward
- 0:40pressure on long-term government bond yields in the U.S.
- 0:43The first one is, of course, the immediate catalyst from the Middle East.
- 0:46The tensions in the Middle east and the renewed tensions of late
- 0:49have led to higher commodities prices, higher oil prices,
- 0:53which are feeding into higher inflation and leading to expectations
- 0:57of central banks around the world tightening monetary policy
- 1:00to prevent inflation from becoming an anchor phenomenon.
- 1:04And what will that mean to the wider economy?
- 1:06Upward pressure in terms of the long-term interest rates
- 1:10tends to lead to a higher cost of capital, which in turn erodes private sector
- 1:16activity and can be a constraint on the global economy.
- 1:20I'm Robin Pomeroy at the World Economic Forum.
- 1:23And with this look at the global economy.
- 1:25There is resilience, but there is also polarisation in the face
- 1:29of numerous shocks that the global economy is being affected by.
- 1:34This is Radio Davos.
- 1:37Welcome to Radio Davos.
- 1:38This week we're looking at the global economy.
- 1:41The World Economic Forum has just released its latest Chief Economist Outlook.
- 1:45That's a regular check of the pulse of the global economy.
- 1:49And to help us look at that.
- 1:51We'll be hearing from a chief economist.
- 1:53And first we'll be hearing from my colleague who writes a lot of analysis
- 1:57on the subject of the economy on the World Economic Forum's website.
- 2:01John Letzing. Hi, John. How are you? I'm very good.
- 2:03Thank you.
- 2:03Robin, it's great to have you again.
- 2:06You've done this the last couple of iterations of the Chief Economist's outlook.
- 2:11Just remind us what it is.
- 2:13So the outlook, is essentially a survey that's administered
- 2:17to a group of chief economists every four months.
- 2:20And it gives us a very good read into what's happening in the global economy.
- 2:24And what they think is going to be happening in the year ahead.
- 2:27Right.
- 2:27And so these are chief economists, banks and other big companies,
- 2:33International organisations, all, all manner of chief economist here.
- 2:36But these are these are big thinkers on the global economy, right?
- 2:39This comes out every 3 or 4 months.
- 2:42And we usually do a Radio Davos episode,
- 2:46which involves us talking to a chief economist.
- 2:48You've done the interview this time.
- 2:52We'll introduce that in a moment.
- 2:53But before we get into that interview,
- 2:55can you give us some of the headlines from this Chief Economists Outlook.
- 2:59As we say it's a pulse check.
- 3:01So you know, is the patient healthy.
- 3:03What what is it telling us about the global economy.
- 3:06Yeah.
- 3:06So context is very important this time around.
- 3:09So this time around
- 3:12the percentage of chief economist that are expecting conditions
- 3:16to weaken for the global economy is actually way down.
- 3:19But if you recall, four months ago when the last survey
- 3:22was administered, we had a brand new war in the Middle East.
- 3:26We had a major trade route through which we usually get a lot of our energy
- 3:30that was going to be impeded. For a while.
- 3:33Things were looking bad.
- 3:34So, it's not entirely shocking that,
- 3:37that percentage expecting a weakening
- 3:40outlook would go down, which it has, pretty dramatically.
- 3:43We went from about nine and ten down to a little less than half.
- 3:47So hold on.
- 3:47They're saying there's fewer people with a very gloomy outlook.
- 3:51Is that right?
- 3:52Stabilising is the word they use.
- 3:54So a lot of people seem to be seeing stabilising in the economy.
- 3:57Is that because the world is just getting used to because the Strait
- 4:01of Hormuz, as we recall, this is still pretty much closed.
- 4:05And there's also threats to the strait on the Red Sea.
- 4:10It doesn't look like things are getting better.
- 4:12Is it just there's a new normal now?
- 4:14Yeah, I think so. I think people are looking
- 4:18at the resilience that the economy has demonstrated.
- 4:21And they are maybe there's maybe a little bit of, optimism in there as well.
- 4:26I think context is important.
- 4:28The last time around things were popping off.
- 4:31They were pretty crazy.
- 4:32And so I think what people are seeing is that despite all that, we're
- 4:37still here, economies are still moving forward, more or less.
- 4:41So, so here we are, the focus of your interview today.
- 4:47A lot of it is talking about inflation and also interest rates.
- 4:52Tell us why interest rates have been in the headlines a lot at the moment.
- 4:58Yeah.
- 4:58So that is a big through-line in this outlook is the cost of living.
- 5:03These chief economists.
- 5:05It's a little bit confusing because their overall expectation
- 5:08for inflation over the year ahead is come down a little bit.
- 5:10Again, context is important.
- 5:12But the basics of the cost-of-living things like food, electricity,
- 5:17the way you can get around and transportation, that's all expected to
- 5:20increase.
- 5:21So what's happening is that central banks are on the spot.
- 5:24They need to manage this somehow.
- 5:27Well, they're supposed to manage it somehow.
- 5:28So we are now looking at a probable interest
- 5:32rate increase in the US, probably in the UK as well.
- 5:36Essentially what central bankers are going to be trying to do through
- 5:40that is to get their arms around inflation to tamp things down,
- 5:44tighten the money supply a little bit and get things back in order.
- 5:48Whether or not it's going to require one rate
- 5:51increase or more is is up for debate.
- 5:54And I should note that we're recording this, last Wednesday,
- 5:5816th of September, which is the day the Federal Reserve is meeting or its,
- 6:03rate decision.
- 6:04People will make that decision.
- 6:07So you'll already know that the UK Central Bank is meeting tomorrow's record.
- 6:12This a by the time you're listening to this, they will have made those decisions.
- 6:15We'll know.
- 6:16But even a decision made if those banks have decided
- 6:20to raise interest rates, a tiny bit, that's not taking further
- 6:23interest rates off the table, is it either.
- 6:25This is a kind of a medium term pressure
- 6:29on those banks to look like they're ready to raise rates to combat inflation.
- 6:34Yeah, that pressure is not going away anytime soon.
- 6:37You also talk about bond yields.
- 6:39This has also hit the headlines recently.
- 6:42Remind us what a bond yield is and why.
- 6:45Again that's in the headlines right now.
- 6:47Yeah that's the biggest part of our conversation because that's sort
- 6:50of the big backdrop to everything that's happening in the global economy.
- 6:53Right now. It's a question of trust, really.
- 6:56How much do investors trust in what governments
- 6:58are doing to manage their economies at the moment?
- 7:00So a bond yield is a great measure of trust.
- 7:03And essentially if the government bond yield is increasing,
- 7:07that means the market is, feeling a little less confident
- 7:12about what that particular country is doing to manage its economy.
- 7:16We've seen yields increase. We've had,
- 7:19what has been described as chaos in the government bond market recently.
- 7:23And in particular, US bonds are in focus because US bonds are this sort of global
- 7:28benchmark, for where the world puts its money and expects returns.
- 7:33And actually, as we were doing this interview or shortly after,
- 7:38one particular yield on the US 10-year Treasury actually hit the 5% mark.
- 7:43And that is a very important mark, psychologically speaking.
- 7:46And we get into that in in the interview a bit. And
- 7:51your interviewee who we'll
- 7:52introduce in a moment gives a very, concise
- 7:56kind of list of things that have caused that.
- 7:59And probably the main thing is, as you mentioned, John, this,
- 8:04concerns about whether,
- 8:07a central bank can control inflation.
- 8:11But there's also other things, including debt. Yes.
- 8:15Investors see debts getting, going in a direction they see is out of control.
- 8:19They will let you know. Right.
- 8:22And other things as well.
- 8:23There's only a certain amount of money floating around in financial markets.
- 8:27A lot of it is flowing at the moment into artificial intelligence.
- 8:30And so perhaps money that would have gone into government bonds
- 8:34and supported those prices is actually going elsewhere.
- 8:38Yes, indeed they have.
- 8:39They have options. These days.
- 8:41Great.
- 8:42Just remind us the relationship between bond prices and bond yields.
- 8:46Yes. Very important.
- 8:47So essentially if a country issues a bond
- 8:51and the bond is worth $5, let's say on the market,
- 8:55and it pays $1 in interest a year, that's all well and good.
- 8:59But if the bond trades down and the bond becomes less
- 9:04less valuable, it becomes worth, let's say, $4 a year.
- 9:07You're still, as the issuer paying that $1 a year.
- 9:10So that spread between the value of the bond and the interest paid
- 9:14is the yield.
- 9:15It essentially pays more to investors.
- 9:17But those investors understand that their investment is a little bit more risky.
- 9:22Central banks
- 9:23raise rates to tamp down the economy and to tamp down inflation,
- 9:29but actually just raising rates in themselves.
- 9:32People are going to be paying more for their
- 9:35for their loans, more for their mortgages, whatever.
- 9:37It's not pretty.
- 9:38It's not it's not a pretty process.
- 9:40I think he he makes that point.
- 9:41There is this kind of conjunction of unfortunate things coming together.
- 9:47So tell us who it is.
- 9:48You're interviewing for this episode.
- 9:51So this episode we had Greg Daco, the chief economist at EY.
- 9:56Greg's got a lot of interesting things to say, particularly on
- 9:59that issue of inflation and of bonds and of interest rates.
- 10:03Let's hear this is you, John, speaking to EY's
- 10:07Greg Daco.
- 10:09Greg, thanks very much for joining us.
- 10:11My pleasure.
- 10:12Thanks for having me.
- 10:13The latest outlook, the keyword seems to be stabilising.
- 10:18That seems to be the overriding sentiment out there anyway.
- 10:22But I'm wondering,
- 10:24is that a good word to describe what you're seeing when you're looking
- 10:27at the global economy at the moment?
- 10:31I think if you look at
- 10:32the latest, survey from the chief economist, they indicates
- 10:35that, more than half expect the economic outlook to remain unchanged.
- 10:39And I think that's really on par with, our own forecast for the global economy,
- 10:44which is one in which there is resilience, but there is also polarisation
- 10:49in the face of numerous shocks that the global economy is being affected
- 10:53by, including tensions on the geopolitical front,
- 10:57including tariffs and trade tensions and of course, this
- 11:00AI led tech revolution, all affecting economic activity
- 11:05in different ways and pushing different economies in different directions.
- 11:09Indeed, and we should note that the context for the last Chief
- 11:14Economist Outlook four months ago, that was a very fraught moment.
- 11:17We just had a brand new war in the Middle East kicked off.
- 11:20It became clear that a vital trade route, through which
- 11:24a big chunk of the world's energy comes through normally was going to be impeded.
- 11:28So that probably explains why about 9 in 10 chief economist
- 11:31at that point saw the outlook weakening over the coming year.
- 11:34But as you note, that's back down to to less than half at this point.
- 11:39In terms of positives, you did mention, AI
- 11:44I guess in some ways that is
- 11:46cited as a positive in the outlook in terms of increased adoption.
- 11:50However, there is another interesting tidbit in the outlook.
- 11:53About 79% of the chief economists
- 11:56seeing some likely pushback to data centre expansion from local communities.
- 12:02And that sort of feeds into the broader
- 12:04sort of tension that you mentioned around AI.
- 12:06And I'm wondering if you think there is a real risk
- 12:09there from this pushback that we might potentially miss out
- 12:12on some of the economic benefits that we'd otherwise get from AI.
- 12:17I think in general, AI is likely to deliver upon its promises
- 12:20of stronger productivity growth
- 12:22and stronger business investment to support that technology.
- 12:25But in the initial phase, there are going to be, some disruptions
- 12:30that are going to affect the labour market,
- 12:31that are going to affect the energy market, and that are likely
- 12:36to see some pushbacks in some segments of the global economy.
- 12:39So I think we have to be conscious of both the potential upside from AI
- 12:44and this technological revolution to lift economic output
- 12:48and offset some of the negative supply shocks, but at the same time, be conscious
- 12:53that this is just not going to be everybody wins all the time.
- 12:58There are going to be some segments of the economy
- 13:01that are affected in a negative way because of potential energy tensions,
- 13:05because of potential energy risks, because of labour market displacements.
- 13:10So it's not necessarily going to be all good or all bad.
- 13:13There are going to be nuances there.
- 13:15And I think that's where there is a great opportunity for the government
- 13:20and the private sector to collaborate in order to ensure
- 13:24that the negative externalities are accounted for
- 13:27and that the technology delivers the most potential in terms of its boost
- 13:32to growth, limiting the negative effects in terms of population,
- 13:36in terms of energy, and in terms of potential downside
- 13:40risks from asset market overappreciation.
- 13:44Yeah, indeed.
- 13:45And these these things, I suppose they can ebb and flow.
- 13:49Do you see this pushback that we're seeing.
- 13:52Do you see that as maybe something that that will recede, at least to some extent,
- 14:00or is it just going to have to be more proactively managed?
- 14:03I think it will have to be proactively managed.
- 14:06What we are currently seeing is the first phase of any technological revolution.
- 14:11And that first phase is very intensive in capital investment,
- 14:15infrastructure investment.
- 14:17We've seen that throughout the ages, from the Industrial Revolution to the
- 14:21electricity revolution to the computer age.
- 14:23There is a first phase that requires a lot of capex investment,
- 14:27a lot of infrastructure investment, and that tends to strain resources,
- 14:31which leads in some cases to pushback, but also leads to inflationary pressures.
- 14:37That is something that people don't always understand.
- 14:40That in the first phase of a technological revolution,
- 14:43there are inflationary pressures.
- 14:45And only once you start to see the gains in terms of productivity
- 14:49that come from skills development, that come from greater diffusion, then
- 14:54you start to see the productivity effects that lead to a disinflationary impulse,
- 14:59and that is the natural evolution of a technological revolution.
- 15:04But we have to be very careful that there can be excesses in the case
- 15:09of this latest technological revolution with AI in terms of positives.
- 15:13And another positive I think we can cite in the outlook is the inflation outlook.
- 15:18It seems that
- 15:20the percentage of chief economists that are expecting inflation to increase over
- 15:23the coming year has declined decidedly compared to four months ago.
- 15:27I guess, you know, as we are recording this, we are anticipating
- 15:31a potential interest rate hike in the US.
- 15:35I'm wondering what your take is on the outlook for inflation.
- 15:38Do you see us getting to a point
- 15:40where it is effectively being tamped down by central banks?
- 15:45What we are
- 15:46seeing is essentially a lot of ebb and flow in the inflation picture,
- 15:49a lot of volatility in the different economies throughout the world.
- 15:53In the earlier May survey, we saw a lot of worries about inflation rising.
- 15:58In the latest September survey, we saw half of the chief
- 16:02economist expecting inflation to rise in half expecting inflation to stabilise.
- 16:06So we're in this unknown uncertain type of environment.
- 16:10But unfortunately with the latest developments in the Middle East
- 16:14and the upward pressure on commodities prices and renewed supply chain
- 16:18disruptions, we're likely
- 16:19to see some re-acceleration of inflation throughout the world.
- 16:23And that's likely to put many central banks on watch.
- 16:27We've already seen a couple of central banks tighten monetary
- 16:30policy in the face of these renewed inflationary pressures.
- 16:34It's likely the Fed will follow suit with some tightening of its monetary policy.
- 16:39And that brings a combo that is a little bit difficult
- 16:42to manage from a growth perspective, because you have higher inflation, higher
- 16:47cost of inputs, higher consumer prices at the same time
- 16:51as you have higher interest rates and a higher cost of capital,
- 16:55which is constraining private sector activity.
- 16:58So that duality is something we have to monitor very closely
- 17:02in the next few months as we navigate into 2027.
- 17:07Okay.
- 17:07And perhaps another thing that raising rates
- 17:11might help us get our arms around is, bond yields.
- 17:15Government bond yields have become very topical recently.
- 17:19One particular U.S. bond especially
- 17:22is making a lot of people nervous for different reasons.
- 17:26And maybe before we dig into this,
- 17:29we could help explain to our audience
- 17:32exactly what is a government bond.
- 17:35Essentially, a government bond is, what the government is willing,
- 17:40to offer in terms of debt, but in compensation for,
- 17:44people financing that debt, it offers an interest on, that debt
- 17:49and that interest is the government bond yield.
- 17:52So essentially, the, private sector is lending money
- 17:57to the government to finance expenditures and potential tax cuts.
- 18:00And as a result, the government, over time reimburses
- 18:04more than the initial loan from the private sector.
- 18:08So that's really what a bond is.
- 18:10And when you have economies that have larger debt, loads and incur
- 18:15greater deficits year after year, then the cost of that debt tends to increase.
- 18:21And that's when you start to see bond yields rise.
- 18:25Okay.
- 18:25Now the average person might look at something in the market
- 18:28rising bond yields and say well that's that couldn't be bad.
- 18:31But help us understand what does that mean effectively
- 18:35if a bond yield is rising what does it mean for that country.
- 18:39Who's issuing that debt.
- 18:41Well it's
- 18:41actually the bond yield is the cost of debt.
- 18:44You can think of it as an interest payment on your own debt.
- 18:48If you buy a car with a loan, you have an interest payment.
- 18:52So you're not just paying the cost of the car,
- 18:55but you're also paying the interest on that loan, which accumulates over time.
- 19:00The longer you take out that loan for the greater the interest payment.
- 19:04Now, in an environment where you are able to reimburse your debts
- 19:09rapidly, then that interest gradually over time fades.
- 19:13But in an environment where you're constantly borrowing more,
- 19:17as many governments around the world are doing running larger budget deficits,
- 19:22that tends to lead to a larger debt load,
- 19:25and in turn, the interest on that debt
- 19:28tends to increase, feeding back into a greater debt burden.
- 19:33And as a result, the compensation that investors and the private sector
- 19:37is asking for to essentially loan to the government is greater.
- 19:42And that is the upward pressure
- 19:43that we see on interest rates and on government bond yields.
- 19:48Yeah. Is it a trust issue in a way?
- 19:50Is it effectively investors saying to governments
- 19:53we're not sure about you as we were maybe a month ago?
- 19:57Yeah, you can see that across different types
- 19:59of economies, economies that have deep, financial markets
- 20:04that have institutional credibility, that have the rule of law, that have,
- 20:09debt burdens that are not excessively high and run deficits,
- 20:14that are either small or in some cases,
- 20:16minor primary budget surpluses.
- 20:19Those economies tend to pay less in terms
- 20:22of the interest rates on their debt.
- 20:25But for smaller economies that have more volatility
- 20:29from a geoeconomic, a geopolitical perspective that have,
- 20:34difficulties reigning in their finances, their government finances,
- 20:38and have rising debt loads, in those cases,
- 20:42you tend to see very high interest rates on the debt.
- 20:46And generally that is also accompanied by higher inflation, which forces
- 20:51the central banks of these economies to tighten monetary policy.
- 20:55In an effort to curb inflation.
- 20:57And that also feeds into higher interest rates and a higher cost of debt.
- 21:02Okay.
- 21:03And there is one government bond in particular that many, many people
- 21:07are focusing on right now, and that is the U.S. 10-year Treasury.
- 21:11And I think, the yield on that has risen
- 21:15to somewhere close to 5% if I'm not wrong.
- 21:18And that's captured a lot of attention.
- 21:21Now, help us understand what is it about this particular bond?
- 21:26That is so important?
- 21:27Why is that 5% mark considered so important?
- 21:31Psychologically?
- 21:33So before we go into the 5% mark, I think it's very important to understand
- 21:37that US debt is generally believed to be central in terms of international lending
- 21:43and in terms of borrowing in the US market,
- 21:47which is one of the largest markets in the world, if not the largest
- 21:51and the deepest, market in terms of financial market activity.
- 21:54So when you think about, the US 10-year yield, and the US ten year
- 21:59Treasury, that is a key asset
- 22:02that is used to price many other assets.
- 22:06And so when you see yields on 10-year government bonds
- 22:10that rise very rapidly, as we've seen, that incurs dynamics
- 22:15that lead to a new cost of capital across the world and across the U.S.
- 22:21Because if you think of corporate borrowing rates or
- 22:24if you think of car loans, or if you think of mortgage loans,
- 22:29all of those are priced in some way in either
- 22:32the 10-year bond yield or in a derivative of the ten year bond yield.
- 22:36So upward pressure in terms of those those long-term interest rates
- 22:41tends to lead to a higher cost of capital, which in turn erodes private sector
- 22:46activity and can be a constraint on the global economy.
- 22:51That is why the ten year bond yield is so much in focus these days.
- 22:55Now, a 5% 10-year bond yield is the highest
- 22:59we would have seen since before COVID.
- 23:02You have to go back to the great financial crisis of 2007 2009,
- 23:07and that is a key reference point, because if you remember,
- 23:10this was the Great Recession, where we had a massive reduction
- 23:15in private sector activity across most economies around the world,
- 23:19and it took quite some time to rebound from that very deep crisis.
- 23:25So that's why this very important gauge is the key point of attention
- 23:30for many investors and many private sector actors.
- 23:33Okay.
- 23:34Now, what has been happening in this bond
- 23:38market recently has been described as chaos.
- 23:42I'm wondering if the
- 23:44if that's overstating it a bit or if you think that's a relatively fair
- 23:48description.
- 23:48And I'm also wondering what started this, because, I mean, governments
- 23:52have been running big deficits for a long time.
- 23:56Inflation has been persistent for a while now.
- 23:58This this war in Iran has has it?
- 24:01Well, now it's several months old. So.
- 24:03So what is it recently that that started all of this?
- 24:07I think there are a few factors that are behind this upward
- 24:10pressure on long-term government bond yields in the US.
- 24:13The first one is, of course, the immediate catalysts from the Middle East,
- 24:17the tensions in the Middle east and the renewed tensions of late
- 24:21in the Middle East have led to higher commodities
- 24:24prices, higher oil prices, which are feeding into higher inflation
- 24:28and leading to expectations of central banks around the world.
- 24:31Tightening monetary policy to prevent inflation from becoming,
- 24:35an anchored phenomenon.
- 24:37Now, that is the cyclical factor.
- 24:40That is really the spark that has led to this upward
- 24:42pressure of late in the 10-year treasury yield.
- 24:45But I would contend that there are several structural factors
- 24:49that are pressuring up long-term bond yields.
- 24:52One, as you mentioned, the fiscal situation in many economies is concerning.
- 24:57You're seeing many economies post-COVID running larger
- 25:00budget deficits than they were before the pandemic.
- 25:03They're also accumulating more debt.
- 25:05So the cost of that debt is increasing too.
- 25:09You have an environment where it's not just about higher inflation.
- 25:12It's inflation volatility
- 25:14that makes it very hard for investors to price the next central bank move.
- 25:18Three you have an environment where AI is pulling a lot of private sector capital
- 25:24in to finance its capex and investment wave.
- 25:28That is deterring some of the investment from going to the public sector.
- 25:32And three and four, you have an environment where,
- 25:36what is happening in terms of central bank credibility
- 25:39is central to how investors are pricing
- 25:43the next central bank move and pricing the cost of that debt.
- 25:47These factors are not going away.
- 25:50They're perhaps not internal, but they are certainly structural
- 25:53in nature, which leads to a higher cost of capital.
- 25:56Add to that one more phenomenon, which I think is very important to highlight.
- 26:00It's the fact that the Treasury in the US has been intervening in markets,
- 26:05intervening to protect a sell-off of treasuries
- 26:09by supporting the Japanese yen, but also intervening in the form of larger
- 26:14debt buybacks to try to put some downward pressure on government bond yields.
- 26:20Those combinations of interventions are signalling to private sector investment
- 26:24some discomfort from the administration in terms of the higher interest rates
- 26:29and in a sense, they are exacerbating some of the pressures
- 26:33and the doubts as to, these higher interest rates
- 26:36and the potential effects they will have on private sector activity.
- 26:40Okay.
- 26:40And just,
- 26:41just so I understand how this works and how nuts and bolts kind of way,
- 26:44is it essentially the U S government going out and buying its own debt
- 26:49to essentially elevate the price and reduce the yield?
- 26:53It is in some
- 26:53way, that it is also, with a means
- 26:57by which the Treasury is swapping some of its debt holdings.
- 27:02Essentially it's, called in some places
- 27:05Operation Twist, whereby you essentially, sell some of the short
- 27:11duration debt and you buy some of the long duration debt.
- 27:14So essentially it's some swapping of, of debt,
- 27:17with an effort or an, an attempt to put downward pressure
- 27:22on long term rates, even if it might put some upward pressure on short term rates.
- 27:27And that is, again, because this ten year government bond
- 27:31yield is central to pricing many assets around the world.
- 27:36Okay.
- 27:36And the AI aspect that you mentioned is very interesting.
- 27:40Is it effectively the case
- 27:43that investors are seeing so much opportunity
- 27:46to buy debt being issued by these AI companies that it's
- 27:51essentially starving, resources
- 27:54that would otherwise be going into U.S. Treasuries, into U.S. government debt.
- 27:58Yes, that's a big part of it.
- 27:59Essentially, you are in an environment where investors have a choice.
- 28:02They can either invest in, Treasury bonds or they can invest in AI.
- 28:09That those are two alternatives.
- 28:10There are many other, of course.
- 28:12But when you're thinking about your potential return on this investment,
- 28:16you have a fairly large potential return in terms of investing in AI.
- 28:21So that's driving a lot of investment into the infrastructure.
- 28:25Buildout the capex,
- 28:26buildout the build out of data centres and semiconductor facilities.
- 28:30All of those investments are going into the private sector.
- 28:34And some of that money that would otherwise have gone
- 28:37into the public sector in terms of safe investments
- 28:40in treasuries, may not necessarily be doing so.
- 28:44At the same time, you also have central banks around the world
- 28:47that are cutting back on the size of their balance sheets.
- 28:51And that means buying less government debt.
- 28:54And so that's another factor
- 28:55that's putting downward pressure in terms of purchases, in demand
- 28:59for government bonds and pressuring up yields as a result.
- 29:03Now, in terms of yields rising and yields rising
- 29:06dramatically, help us understand a little bit of historical context here.
- 29:09What are some situations in the past where we've seen in different
- 29:12countries yields rise this sharply?
- 29:16Essentially what needs to be happening usually historically in a country
- 29:20for that to happen.
- 29:22Generally speaking, when,
- 29:24a country is running a large fiscal imbalances imbalance,
- 29:28when it's running a large deficit, that is when you tend to see
- 29:33upward pressure on government bonds.
- 29:36Generally, those economies that are running large budget
- 29:39deficits are also seeing higher inflation and in some cases,
- 29:44a need for central banks to tighten monetary policy more aggressively,
- 29:50i.e., raise short-term rates to try to combat inflation.
- 29:55And so in these economies that have large budget deficits,
- 29:58elevated inflation and central banks that are trying to tighten
- 30:02monetary policy, you tend to see significantly higher
- 30:06government bond yields, because these longer-term bond yields
- 30:10reflect both the expectation of higher short-term interest rates,
- 30:14as well as a higher cost of that debt that keeps rising and rising year after year.
- 30:21So those are the characteristics that you tend to have
- 30:25in economies that have high government bond yields.
- 30:29And I guess
- 30:29it's you know, there was a period in the UK
- 30:32a few years ago, I think, 2022, where the bond market,
- 30:37it was essentially credited with pushing out a prime minister at that time.
- 30:42And people often talk about, you know, bond market
- 30:45vigilantes, this sort of function of bond markets,
- 30:48as a kind of ultimate reality,
- 30:52a kind of final boss, if you will.
- 30:54Do they really function that way?
- 30:56I mean, are they sort of a final judgement on the way an economy has been managed
- 31:00in a way that is, is in some ways the last word?
- 31:05In a way, yes.
- 31:06In the sense that, bond markets price the cost of debt.
- 31:10And if investors do not trust the government's ability
- 31:13to repay those debts, if they do not trust a central bank
- 31:17to be able to raise short term interest rates in terms of controlling
- 31:22inflation, then, they demand a higher compensation
- 31:27to buy that government debt and that risk premium
- 31:31is what leads to higher interest rates for government bond yields.
- 31:36You're absolutely right to point to certain risk-off environments
- 31:40that we've had in the UK, back a few years ago, but also in the US,
- 31:45where you have these sudden surges in government bond yields
- 31:49that lead to a pullback in private sector activity
- 31:52and sometimes are accompanied by a correction in the equity market
- 31:58because the discount factor is that much greater.
- 32:01So yes, it is true that you tend to see in some cases when economies
- 32:06propose budgets that are not realistic or when they propose, different types
- 32:12of spending measures that will lead to a widening of the budget deficit.
- 32:17That is when investors demand greater compensation for those bonds.
- 32:22And as a result, you see upward movement upward
- 32:25pushes in government bond yields.
- 32:28Okay.
- 32:29So, functions as a sort of reality check.
- 32:32It sounds like it does function as a reality check for the cost of that debt.
- 32:37And it functions as essentially an estimation of the cost of that debt,
- 32:42including the risk of putting your money
- 32:45into government bonds that are generally considered to be safe,
- 32:48but can in some cases not be as safe as marketed.
- 32:53Now, with what's been happening in the bond market yields rising, it's
- 32:56obviously it's going to make it more expensive for governments to borrow,
- 33:00but the average person
- 33:02probably has limited to no contact directly with the bond market.
- 33:06So should they be concerned about what's happening in the market?
- 33:10I mean, what is
- 33:11what is the relation or the possible relation between the price of a bond?
- 33:14Let's say, and somebody's grocery bill?
- 33:17So essentially when you think about government bond yields
- 33:21and you think about the cost of that debt, it's essentially
- 33:24a great reference point for many loans
- 33:28that, private sector actors take out.
- 33:31If you think about the average household in the US buying a car,
- 33:35the cost of the loan on that car
- 33:38will be anchored to the 10-year government bond yield.
- 33:41So if the ten year government bond yield is rising to a 20-year high,
- 33:46there is a very high likelihood
- 33:48that the cost of that auto loan will also rise in sync.
- 33:52You can think of the same when you're buying a house and taking out a mortgage.
- 33:56Mortgages are priced off of the 10-year and the 30-year government bond yields.
- 34:01So if there is upward pressure on that front,
- 34:04that will lead to a higher cost to take out that mortgage.
- 34:08And for the private sector, for private sector companies,
- 34:11you also have this phenomenon whereby if a company is looking to take out
- 34:16a corporate bond that will be priced off the 10-year government bond yield,
- 34:20so a higher ten year government bond yield will lead to higher cost
- 34:24of borrowing from the private sector and perhaps lead to a pullback
- 34:29in investment intentions and in hiring intentions,
- 34:32which could cut back on private sector activity.
- 34:35Okay.
- 34:36And can you give us a sense
- 34:37of how long these things usually take to play out within a system?
- 34:41So let's say someone is seeing what we've seen in the bond markets recently.
- 34:46I mean, what would be a reasonable expectation for when that would start
- 34:49showing up tangibly in their day-to-day lives, potentially?
- 34:54I mean, in some cases, it's almost immediate.
- 34:57If you're trying to buy a house today in the US,
- 35:00then you're going to be paying much more in terms of your mortgage rate
- 35:05than you would have just six months ago, because there has been significant
- 35:10upward pressure on both the ten year and the 30 year government bond yields.
- 35:14So it's near immediate in terms of the cost of that debt.
- 35:18Now, it's very important to remember that we don't take out loans on a daily basis.
- 35:23For the most part,
- 35:24what happens is that a lot of that debt is fixed at a certain point in time.
- 35:28So unless you need to refinance that debt
- 35:31or take out a new loan, you don't always get the one-for-one effect.
- 35:35In terms of private sector activity, it affects only
- 35:38the marginal buyer of that debt that wants to invest,
- 35:42wants to hire, wants to buy a house, but it's a gradual effect
- 35:46that filters through whenever somebody needs to refinace a loan
- 35:50or to take out a new loan for new private sector activity.
- 35:54Okay, so let's maybe take a step back
- 35:56and imagine that the Iran war ends tomorrow.
- 36:01That central banks around the world
- 36:03take a very firm hands with inflation by raising rates.
- 36:08Does the bond
- 36:09market issue go away, or are there longer term issues
- 36:13that need to be addressed for for this to sort of settle back to normalcy?
- 36:18Well, I think one thing to realise is that the global economy
- 36:21has been affected by several negative supply shocks, including tensions
- 36:26in the Middle East, including tensions in Ukraine, including,
- 36:30the recent rise, a renewed rise in tariffs,
- 36:34that the US has imposed on some trading partners.
- 36:37And all of those are leading to a higher, interest rate environment
- 36:42because they're crystallising into higher inflation.
- 36:45Now, if the Middle East conflict were to end tomorrow
- 36:48and oil flows were to resume rapidly, then what you would see is essentially
- 36:53both a reduction in inflation pressures from reduced energy prices,
- 36:58a reduction in inflation expectations because of that
- 37:02positive resolution to the Middle East conflict.
- 37:05And that will lead central banks
- 37:07to essentially contemplate maintaining their current policy stance.
- 37:11Overall, those evolutions would essentially lead to lower
- 37:16long-term interest rates, but we should not forget
- 37:20that the structural factors that are still putting upward pressure
- 37:24on long-term government bond yields are still going to be present.
- 37:28You're still going to have an environment where government finances
- 37:31are under pressure.
- 37:33You're still going to be in an environment where there is inflation volatility.
- 37:37You're still going to be in an environment where there's
- 37:39a massive call for private capital from the AI revolution,
- 37:42and you're also going to be
- 37:44in an environment where central banks credibility is in doubt.
- 37:48And in some economies, there are questions from investors
- 37:51as to how resolute the commitment of a central bank is to control inflation.
- 37:57Okay.
- 37:58And do you see a point coming, maybe relatively soon, where governments
- 38:03really have no choice but to answer to the bond markets
- 38:06and start doing what, what the bond markets are suggesting?
- 38:12I would hope so,
- 38:13because we have to have some type of,
- 38:16resolution to ever rising government debt loads.
- 38:21It's often the case that you don't know when a crisis is going to occur,
- 38:27but running larger and larger budget
- 38:30deficits year after year after year
- 38:33leads to an accumulation of debt that rises to very high levels.
- 38:38And in turn, the interest on that debt keeps rising, which puts upward
- 38:43pressure on interest rates, which lead to higher interest payments on that debt.
- 38:48And you have a snowball effect there that can lead to higher
- 38:52inflation and force central banks to tighten monetary policy.
- 38:55So I would hope that some of the pressures that we are seeing today
- 38:59in terms of running, an environment where we have the 10-year Treasury
- 39:03yield approaching 5%, would force policy makers
- 39:08to take action over a long period of time, controlling expenditures
- 39:14on, the healthcare front, on the ageing front,
- 39:19ensuring that the tax base is solid enough to generate revenues
- 39:24on an ongoing basis and allow for budget deficits
- 39:28to not be structurally higher, but instead be structually smaller.
- 39:32As the global economy continues to grow.
- 39:35I think we'll leave it there.
- 39:36Greg Daco, thank you very much. Thank you very much.
- 39:40Greg Daco, chief economist at
- 39:42EY was talking to my colleague John Letzing.
- 39:46You can read the Chief Economists Outlook on our website.
- 39:49There's a link in the show notes to this episode,
- 39:52and you can find all episodes of Radio Davos at wef.ch/podcasts,
- 39:57where they also find our other two weekly podcast, Meet the Leader
- 40:01and Agenda Dialogues.
- 40:02This episode of Radio Davos was written presented by me with my colleague John.
- 40:07Letzing and we'll be back next week.
- 40:09In the meantime, thanks very much to you for listening and goodbye.