CHESS Chart: Reading History through Interest Rates


No one would call government bond yields sexy, but sometimes its the arcane details that move history. While most people were focusing on the antics of the New Hampshire primary, the Bank of Japan lowered interest rates below zero on some of its accounts. What followed was near panic in the bond market and a further decline in sovereign debt yields (the return investors receive when they hold that bond divided by the face value), which are now near or below zero for Japanese, Swiss, and German 10-year bonds. There’s now $7 trillion in government debt worldwide with yields below zero (where investors are actually paying to hold the bond) and that number seems likely to grow. All of this tells us that markets are expecting low inflation and slow growth for the foreseeable future despite the best efforts of central bankers and policy makers alike.

With the recent kerfuffle in the bond market, now is a great time revisit the history of government bond yields. Not only can yield rates help predict recessions, they can tell us a great deal about why the past turned out the way that it did. Yields reflect investors’ confidence in both the government’s ability to pay back its creditors as well as those creditors’ faith in the economy. For that reason, yields tend to go up during wars. Not only does the government’s demand for credit increase so too does the risk that investors might not get paid back (a country that looses a major war will have a much harder time paying back its debts).

In the eighteenth century, the difference between Britain’s lower borrowing costs relative to France reflected investors’ greater confidence in its political and financial system. Not only did Britain have a Parliament committed to paying the country’s debts (it helped that creditors were also often voters and Members of Parliament) but a central bank that managed those debts. The difference in interest rates also helps explain why Britain eventually defeated its larger geopolitical rival, especially during the Napoleonic Wars when inflation and uncertainty drove French borrowing costs through the roof. Bond yields also show how the ratification of the American constitution and the assumption of state debts during the 1790s (Hamilton really does deserve his own musical) not only brought inflation and borrowing costs under control but generated new confidence in the political and economic future of the United States.

Yields still reflect investors’ assumptions about the likelihood of default, but high yields don’t necessarily mean that they think that a government is likely to go bankrupt. In the 1950s and 60s, Japan’s economy boomed, but bond yields went up because inflation was quite high and because the government encouraged people to invest their savings in the country’s rapidly expanding industries (rather than buying government bonds). More recently, yields on government bonds have fallen, despite the fact that governments are increasingly in debt. All of this suggests that investors have a lot more confidence that these governments will remain solvent than that they will succeed in reviving their economies–a daunting prospect and one for which there is little historical precedent.

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