The recent surge in global bond yields is partly ascribed to market worries about a greater supply of debt coming from governments. Some of this increase in yields should reverse when inflation nears central banks’ targets and monetary policy is less restrictive.
But central banks will also add to the supply of government bonds over time as they unwind their unprecedentedly large balance sheets – ranging from 30% of GDP for the US Federal Reserve (Fed) to 50% of Eurozone GDP for the European Central Bank (ECB) – substantially larger than the average amount of around 10% of GDP that central banks held before the Great Financial Crisis (GFC).
The Bank of England (BoE), the ECB, and the Fed have already begun unwinding through the reduced reinvestment of maturing assets, and all three have indicated that they plan to normalise their balance sheets substantially over time. Their objective is to get ‘out of the unconventional mode’ and operate monetary policy primarily through interest rates. Some central bank officials may also want to put more government debt in market hands as part of the toolkit to tighten policy.
Whether they can pull this off in an orderly way without triggering much higher yields, with markets being asked to absorb a much larger amount of debt, remains to be seen against a backdrop where governments continue to run large deficits. It will also depend on how fast they normalise, how much is unwound and how much more government debt markets will be asked to fund.
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