The logic is that:
- To attract more investors to buy government debt, we need to raise bond yields.
- Rising debt levels make markets nervous about the governments ability to repay. Therefore, markets demand a higher interest rate to compensate the increased risk.
However, in the case of the US and to an extent the UK, there has been a marked rise in debt to GDP ratios, but bond yields have remained very low.
In the US, 10 year bond yields are currently 2.5%, down from just below 4% in 2008. This is despite a rise in national debt as a % of GDP from 70% to 87% (May, 2010)
- Investors want to buy government bonds because they are seen as a better investment than private sector investment. In a recession / sluggish recovery, there are few investment opportunities in the private sector. Banks are reluctant to lend to private business. Mortgage deals are scarce. This means banks have surplus liquidity, they are choosing to buy government bonds.
- Rise in the Savings Ratio. A typical event in a recession, is for the savings ratio to rise. Consumers and firms are risk averse; therefore they save rather than invest and spend. These savings may be deposited in banks - at very low interest rates or it may be used to buy government bonds at slightly higher, but still low interest rates.
- Market expectations that debt levels will be brought under control in the long term. The rise in debt to GDP levels is seen as a temporary response to the financial crisis and recession. Markets expect when the economy recovers governments will be in a position to raise taxes, reduce spending and tackle the structural deficit. There is also an expectation that economic growth will help reduce the debt to GDP ratios over time.
- If markets didn't expect the Debt to GDP ratios to fall in the long term, then interest rates would be rising, as insolvency fears would be much greater.
Do Markets Adequately Price Bonds?
Markets are far from perfect in anticipating correct price and interest rates on bond yields. Earlier in the year, the sharp rise in Greek bonds showed that previously markets had been underestimating the risk of Greek bonds. However, markets can also over-react in the other direction. There can be a snowball effect as investors pull out of a particular bond.
Currently many say we should be slashing government debt because markets will soon be demanding higher interest rates on bond yields. However, in a recession - in a liquidity trap - it is important to bear in mind, markets may have a surprising appetite for government debt. The rules are different to what is prudent for a government to borrow during a period of full employment.