Karthik Sankaran is a senior research fellow of geoeconomics in the Global South program at the Quincy Institute for Responsible Statecraft.
European markets have faded to the background of the global news cycle lately, perhaps for obvious reasons. But a recent move shows why it’s dangerous to equate rising bond yields with market vigilantism.
Both the euro and European stocks rallied when incoming German Chancellor Friedrich Merz decided to suspend the debt brake his party had long championed, however problematically. This is best understood as investors’ realisation that Germany will probably use its extra fiscal space to boost both its capacity for deterrence and its neglected infrastructure.
In an annoying but unsurprising turn, some luminaries suggested that rising Bund yields meant markets were punishing Germany for abandoning its long-standing thriftiness. Such takes came from fiscal hawks such as Twitter debt scold Holger Zschaepitz and Dr. Lars Feld, a former head of the German government’s economic advisory council.
But this view failed an elementary test of market revolt against an allegedly unsustainable fiscal expansion. That’s because the euro appreciated as Bund yields rose.
To veterans of crises in emerging markets and the Eurozone, DEFCON 1 is only declared when rising yields come with a depreciating currency. This is the sign that followers of UK political economy (over)invoked during Elizabeth Truss’s brief sojourn in office, when the bond/FX market binary treated Britain briefly as a Kwasi-EM.
Conversely, rising yields and an appreciating currency are almost always an indicator of market confidence.
And from a broader perspective, the relationship between currency strength and bond prices captures investors’ broader views about the links between an issuer’s economic outlook and its creditworthiness.
If a bond’s price falls/yield rises when the economy’s cyclical prospects deteriorate, it’s a “credit product”, because the market thinks slower growth means the issuer’s is less likely to service its debt.
If a bond’s price rises/yield falls when the economy’s cyclical prospects deteriorate, it’s a “rate product.” The price increase suggests that it is considered one of the safest assets denominated in that currency, EVEN IF cyclical prospects for the issuer lead to a fall in revenues and a rise in spending. These developments would be considered negative for creditworthiness for any other issuer.
What makes a bond a rate product? Well, that’s largely the market’s read on the issuer’s power and resilience. A large country’s government, for example, has far longer horizons than a single firm. Certain governments’ liabilities have other desirable characteristics, detailed here. And rates products are, by and large, issued by countries with central banks that have earned some credibility with the markets.
This is an important distinction. If a bond falls into investors’ “credit” category, it’s seen as riskier, and that means it amplifies economic cycles. When a slowdown pushes yields higher (or gives it a higher spread relative to a comparable safe asset) that not only raises borrowing costs, but also exacerbates concerns about creditworthiness, creating a vicious circle. If a bond is grouped into the “rates” category, that dampens cycles — lower yields in a slowdown can ease debt service by permitting refinancing while stoking a renewed expansion of activity.
It might help to bring currencies back into the picture and ask a similar question that we have asked about bond markets — does a weaker currency act to stimulate activity or to constrict it?
The answer to this question illuminates another big divide. A weaker currency can constrict activity if a country owes a lot of debt in a foreign currency, or even if it has lots of external investors in its local currency market. (The latter group is more prone to run at the first sign that their assets are losing value versus their own liabilities.) Same goes if a country has lots of flighty locals who view currency weakness as a reason to pull money out of the banking system — do a capital flight, in other words. These are all times when currency weakness will constrict financing.
The economic problems can be compounded if a country has concentrated economic exposure to one productive sector that’s relatively less able to benefit from currency weakness. Consider, for example, the travails of Nigeria in the immediate aftermath of the US’s shale revolution. It helps to have the ability to flood the world with lots of different kinds of cheap exports when your currency weakens. A less varied export mix, or one that’s heavily dependent on foreign inputs, does not.
When a country’s currency weakens, it helps if it has two things going for it. The first is a low pass-through from FX to domestic inflation (which means the cheapness “sticks” in real terms); the second is a central bank that does not overreact to currency weakness by pushing interest rates so high that it fuels concerns about longer-term debt sustainability which then weaken the currency further. (Readers may want to look at the actions of Banco Central do Brasil in 2015 and 2024).
The lists above illustrate financial conditions that developing countries might aim towards — Getting To Rate Product, which might be the macro resilience equivalent of the political science concept of “Getting To Denmark.”
But one international co-ordination problem is that countries in the global south that have “gotten to rate product” have often taken a route that is looked upon with disfavour now (see Michael Pettis’s work).
This route involves accumulating reserves, running persistent trade surpluses, “exporting” persistent disinflationary pressures overseas, and implementing capital controls, among other things. But they’re at least externalising a portion of their adjustment costs, rather than being left on their own to fester in the “you’re so screwed” outcomes in the diagram below. And notably, their export of persistent disinflation might also have given bonds in developed countries more of the attributes of pure rate product, and, consequently, more fiscal space to deal with downturns, which was not always true in the 1980s. If only the wretched ingrates in developed markets chanceries realised that.
And here’s a tool to help you keep tabs on how all of this works (or not). Enjoy, and if you’re a policymaker, try to find your way to the happy places.
https://www.ft.com/content/231fe5d5-01fc-48d1-aeed-27106b078a1a
