Citigroup warns that the rapid increase in bond yields poses a significant risk to the global economy, with yields likely to remain high in the medium term. The bank notes that the global economy has absorbed a significant energy shock since late February, but the production side of the economy is more flexible and adaptable than it was a decade or two ago.
Government Debt Driving Bond Yields Higher
The rise in bond yields is attributed to several factors, including increasing public debt levels and government bond issuance, particularly in the United States. The total amount of government bond issuance is expected to reach $25 trillion over the next decade, and investors are demanding a premium to hold this increasing amount of debt.
The increase in bond yields is also driven by the rapid growth in investments in artificial intelligence, which are largely funded through credit markets with long-term maturities. This has put upward pressure on yields, and the trend is expected to continue as AI investments are projected to more than double in the coming years.
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The term premium and risk premium have also increased due to significant uncertainties in the global economy, including concerns about domestic politics in major countries, geopolitical pressures, and concerns about the shape and stability of the global economic order. Additionally, the neutral short-term interest rates may have risen, with many central banks recently increasing interest rates.
Inflation Expectations and Central Bank Targets
Citigroup notes that the most important factor for bond yields is whether central banks will be able to bring inflation back to their target levels. The levels of bond yields would be very different in a world where core inflation indicators are moving at 2% compared to a world where inflation remains stuck at 3%.
However, the bank remains optimistic that central banks will be able to achieve their goals, although it requires a certain level of confidence. The good news is that long-term inflation expectations in major economies have remained under control during this period, with breakeven inflation rates for a decade-long horizon in the US, euro zone, and Japan ranging around 2%.
In terms of specific bond yields, the 10-year Japanese government bond yield has risen significantly, from near zero to higher levels, which Citigroup sees as a sign that the process of reflation in the Japanese economy has taken hold. Similarly, yields have risen in other major countries, including the US, UK, and France, where fiscal situations are particularly precarious.
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The yield on 10-year bonds has increased by 60-100 basis points in a wide range of countries since the start of the conflict in Iran in February, driven by higher oil prices, rising general inflation, and various other uncertainties. Notably, Korea and the US, both significant producers of artificial intelligence, have seen the largest increase in yields, followed by the Philippines and the UK.
Energy Prices Pose Major Threat to Economy
Higher energy prices present a major threat to the global economy. Oil prices have recently moved above $100 per barrel. Distilled product markets, including gasoline, diesel, and jet fuel, show tighter supply than crude oil markets. Global refining capacity is extremely limited. Gasoline prices have risen faster than oil prices by about 20%. Diesel prices have increased by nearly 50%. A potential ban on diesel exports from the United States poses further risks to these markets.
US fiscal deficits are projected to reach 6% of GDP throughout the next decade. The total volume of government bond issuance is expected to approach $25 trillion. Investors demand a premium to hold this rising volume of debt. High deficits exist in many countries, including Germany.
