Is Fiscal Austerity Being Rewarded?

From the IMF to the G20, from bloggers to Nobel prize winning economists, there have been calls for the major developed countries to reduce deficits and stabilize debt to GDP ratios. The idea is that if this is done properly it need not retard growth and the markets will reward countries with lower interest rates requiring reducing the risk premium.

This is an important hypothesis, but so far the evidence is not compelling. In fact, leaving aside the UK for the moment, those countries that are more aggressively addressing their fiscal excesses as seeing the largest rise in interest rates. And that increase in rates is not simply something that happened earlier this year, but is continuing to take place in recent weeks.

Ireland is, for example, pursing among the most aggressive fiscal policies and yet it's 10-year yield is up 60 bp in the past month and 107 bp in the past 3-months. The 2-year yield has risen 41 bp in the past month and 100 bp over the past three months.

Spain is also tightening fiscal policy and its 10-year yield has risen 22 bp in the past month and 74 bp in the past 3-months. It's 2-year yield has risen 38 bp in the past month and 158 bp in the past 3-months.

Because of the ECB's bond purchases, believe to be concentrated in Greece and secondarily Portugal, they have been excluded from this review.

Germany has unveiled its own plans to reduce its deficit. Over the past month, the 10-year yield is off 8 bp and over the past 3-months the yield has fallen 49 bp. The 2-year has risen 17 bp over the past month and is off 28 bp over 3-months.

Compare these performances of with the US, which seems strikingly behind Europe (and Japan) in laying out a strategy to reduce the fiscal deficit. Over the past month, the US 10-year yield is off 9 bp and 94 bp in the past month and 3-months respectively. The US 2-year yield is off 15 bp and 44 bp in the same time period.

In this review of the bond market performances, it does not appear that those countries that are cutting deficits are being rewarded with lower interest rates. The US, which many perceive as a profligate spender, has seen its yields decline more than more austere countries.

The UK appears to stand out as an exception. Over the past month, its 10-year yield has fallen 22 bp, while the 2-year yield has fallen 14 bp. A hypothesis that would explain the US and UK performance is the reserve status of the dollar and sterling. Agreed, it was not picked up in the Q1 COFER data out yesterday, but both bond markets appear to be drawing support from flight out of continental Europe.