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Chief Economists Outlook: what bond yields and interest rates tell us about the global economy · Radio Davos

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