Behold 2011, the year of sovereign shocks

Government debt

Behold 2011, the year of sovereign shocks

Get ready for more volatility in government bonds

IF YOU want to know what to worry about in 2011, here’s a place to start. Sovereign-bond yields are rising—not just in beleaguered economies on the edge of the euro zone, but across much of the rich world. During the first two weeks of December Spain’s ten-year borrowing costs hit 5.5%, the highest rate in more than a decade. Yields on American ten-year Treasuries jumped more than half a percentage point to 3.5%, a six-month peak. German ten-year Bunds rose to 3%, a yield not seen since May. This simultaneous shift in the rich world’s core as well as the enfeebled euro periphery raises two questions. Are the rising yields being driven by similar forces? And are they the harbingers of a broader bond-market bust?

The pessimistic interpretation is that this reflects concerns about America’s fiscal mess (see article), in a paler version of bondholders’ jitters about Greece and Spain. The worriers point out that bond yields jumped after the recent announcement of a tax-cut plan that is likely to add some $800 billion to America’s public debt over the next decade, and which utterly fails to explain how the country’s medium-term finances are to be sorted out. Likewise, Germany’s dearer borrowing costs may have less to do with optimism about its economy than with concerns about the costs to its exchequer of keeping the euro zone together.

But optimists argue that the scale of the bond-market moves and the dynamics behind them are totally different in the core and in the periphery. Investors may be fretting about the Irish or Spanish governments’ ability to pay their debts, but elsewhere, especially in America, the rise in bond yields—from extraordinarily low to merely very low—is a reflection of better growth prospects rather than worsening government finances. As the economy accelerates, the risk of deflation recedes, private investment rises and the Fed is less likely to engage in further rounds of quantitative easing (printing money to buy bonds). These shifts all push government-bond yields up, but they are a cause for cheer rather than gloom.

So far the evidence suggests that it is confidence rather than fear that has pushed bond yields up of late. In America especially, a rising stockmarket, the strength of the dollar and absence of a spike in credit-default swaps all suggest the recent bond-market sell-off is being driven by hopes for growth rather than by fear of deficits.

In the coming year, however, a different dynamic may take hold. The surge in private savings in the wake of the economic crisis has masked big changes in the rich world’s sovereign-bond markets. First, governments are much more indebted, compared both with their recent past and with fast-growing emerging economies. At 70% of GDP, the average rich economy’s net sovereign debt is 50% higher than it was in 2007, and more than twice as high as the average debt burden in emerging economies. That has happened at a time when the rich world’s growth prospects are deteriorating. Second, with budget deficits still gaping and lots of short-term debt coming due, many governments’ financing needs are rising. Calculations by the Institute of International Finance, a bankers’ group, suggest that America needs to raise over $4 trillion in 2011 and European governments collectively need to borrow almost $3 trillion. Japan, with the world’s highest government-debt burden and short maturities, must raise funds worth more than 50% of GDP by the end of 2011.

Meanwhile, policy uncertainty has increased. Quantitative easing means that central banks now have a big role in long-term government-bond markets. Worries are sharpest in the euro zone, not just because sovereign defaults are now regarded as a distinct possibility, but also because policymakers have managed to confuse sovereign-bond holders by offering them no losses in the short term and plenty in the medium term.

New year’s irresolution

Amid all this uncertainty, only one thing is clear: sovereign yields are likely to rise, and even the strongest governments cannot afford to be sanguine about a bond-market bust. America may be the issuer of the world’s reserve currency, but its debt markets are not immune to a sudden upward lurch, which in turn could threaten the fragile recovery.

Governments could, and should, minimise this volatility. America needs to complement its short-term tax cuts with an agreement on medium-term deficit reduction. Japan should kick-start growth and overhaul the tax code. But the most urgent task is in Europe, where leaders need to blend inconsistencies between today’s rescues and tomorrow’s reform proposals into a coherent plan for managing the euro.

There are, unfortunately, few signs of any of this happening. That is why 2011 could be a year of more, and bigger, sovereign-debt shocks.