The financing costs of sovereigns are under scrutiny. Yields have risen considerably worldwide, especially in the case of long-term bonds. However, we believe that there has been a misdiagnosis of the underlying causes, and therefore, of the necessary solutions that have led us to this situation.
This is not a fiscal crisis (Yet)
Fiscal policy is important for bonds. Very important. But, contrary to recent comments, we see no evidence that the rise in yields is due to an increase in sovereign credit risk.
In the US, which has one of the worst public debt trajectories of all major economies, long-term yields are rising less than short-term yields. US Treasury bonds are performing better than swaps and their international counterparts. The sovereign CDS of the United States have fallen in recent weeks. None of this data aligns with the explanation that the rise in yields is due to greater concerns about the solvency of the US.
The CDS is decreasing...
It is not the increase in credit risk that is driving yields higher. This does not mean we should be complacent about future sovereign credit risks or assert that concerns about debt dynamics are not valid. They are.
The debt trajectories among developed countries range from bad to very bad. We simply observe very few signs that they have been a factor in the recent revaluation.
Moreover, the attention the market pays to these fiscal sustainability dynamics largely depends on the context: when inflation is low or trending downwards, these fears can, and often do, subside. When inflation is too high or monetary policy tightens, they quickly resurface, as is happening now. In other words, fiscal fears tend to evolve in virtuous or vicious circles.
So, if it is not the risk of fiscal credit, what is causing the revaluation of bonds? In our opinion, the real reason for the recent rise in global yields is something more banal.
A bad combination
A bad combination of fiscal and monetary policies that will prevent inflation from reaching 2%. This is, in one sentence, the fundamental cause of the current weakness of bonds. Tackling inflation would also significantly ease the resolution of many other problems.
The starting point is simple and well documented: global supply capacity has been hampered by various crises, the most recent in the Middle East, and the demand for investment from the private sector is exceptionally strong, as generational investment in artificial intelligence infrastructure coincides with a global manufacturing investment boom in "old economy" sectors, largely linked to the global desire to develop greater defence and energy security capacity.
With this context of private demand, monetary and fiscal policy are too loose to sustainably achieve 2% inflation, especially in the US.
We believe this combination of policies is crucial: what matters is not monetary policy alone, but how fiscal and monetary policy interact. If fiscal policy were reducing the economy's demand, monetary policy would be sufficiently restrictive to meet inflation targets. But that is not the case, which is why it does not achieve it.
In our view, this explains the true importance of fiscal policy in the recent rise in yields: it is not so much about sovereign credit risk, but rather about the creation of excessive demand that the economy cannot absorb. The net result is inflation above target. Without fiscal discipline, a more restrictive monetary policy must act as a balancing factor. It is the safety valve.
Unfortunately, we cannot make inflation disappear by magic. As fixed-income investors, our lives would be much easier if we could.
