Yield Curves and Government Finances
(Published 4 October 2023)
Pre and post GFC, the Japanese credit cycle has been a useful guide to understand the future credit cycle and monetary policy of other over-indebted developed economies:
Private sector debt extension to a state of over-indebtedness.
In the absence of QE, private sector deleveraging, despite ZIRP.
Significant increases in government borrowing to compensate for private sector deleveraging, thus preventing a full blown “debt deflation” environment.
Until QE is enacted, asset valuations remain stagnant due to private sector investments being “crowded out”.
The rise in government debt eventually puts pressure on deficits, necessitating a permanent QE status, which leads to currency debasement and a direct link between monetary and fiscal policy.
The yield curve relationship to interest rates has to remain “flipped” to that of bull flattening/bear steepening (as short end remains pegged at low levels), and the absolute level of the yield curve cannot materially rise.
In this context, the recent tightening of global monetary policy by Central Banks (ex BOJ) has unsurprisingly led to a decline of credit growth and money supply (in some countries they are contracting)
The curve relationship “re-flipped” back to the traditional bear flattening/bull steepening as monetary policy was tightened, as front-end rates drove the curve shape.
The combination of increased deficits and QT has put upward pressure on government bond yields - bullish sentiment for private sector assets has waned and is turning bearish.
Most recently, however, the curve has bear steepened, which will put further upward pressure on government deficits – the longer this persists, the greater and long lasting the deficit problem