Volatility in the bond markets across the world, but especially in the United States, has grabbed the attention of the media and policymakers in recent months. We sat down with Carmen Reinhart, the Minos A. Zombanakis Professor of the International Financial System at Harvard Kennedy School, to better understand what the markets are responding to and how their fluctuations can be understood. Reinhart, an affiliate of the Mossavar-Rahmani Center for Business and Government and the Harvard Center for International Development, is an expert on financial crises and sovereign debt. She has served as the senior vice president and chief economist at The World Bank Group, chief economist at Bear Stearns, policy advisor and deputy director at the International Monetary Fund, and member of the advisory panel of the Federal Reserve Bank of New York, and the Congressional Budget Office panel of economic advisors.
Q: How do fluctuations in the bond market impact domestic economic issues like interest rates, inflation, and consumer borrowing?
Reinhart: When we speak about the bond market, it is important to understand the dominance of the United States in that space and the size and influence that the United States has globally. Issues in the United States matter globally. Policy interest rate increases usually drive bond yields higher, but the Federal Reserve has held its policy rate steady, so far.
What we are seeing now is a market reaction to the announcement of tariffs and their shifting size and scope.There are things happening in the United States that are concerning if you are an investor. There is great uncertainty in the markets after “Liberation Day” and also the continued accrual of government debt and fiscal deficits. Higher bond yields have longer term effects, as they increase debt servicing costs over time. Interest outlays have to be factored into the fiscal decisions governments make
Moody’s recently downgraded the U.S. sovereign rating from its previous AAA status, on concerns about fiscal deficits over the foreseeable future and the lack of policy actions to address this. Uncertainty about how the United States is going to approach tariffs, trade, and the corollary effects that will have on economic growth did not help.
Q: How do changes in interest rates affect how investors assess default risk?
Reinhart: Clairvoyance would help, but that is not an option for me, so the next best option is to focus on specific measures and signals. For example, the tightening of monetary policy by central banks raises interest rates. Increases in interest rates make it more likely borrowers will default, because it costs more to service their debt. An environment where default risk is perceived to be higher is often referred to as “risk-off,” where investors become more cautious about what assets they hold.
For governments, fiscal policies may have to change to deal with the increased cost of debt servicing. Whether governments adjust their spending or taxes importantly depends whether they view the change in the cost of borrowing as transitory or permanent. If the change is perceived as temporary, the government does not necessarily change its course of action. But if the change is perceived as more persistent, then adjustment becomes necessary.
The same is true for investors (including those in the bond market). If higher interest rates are expected to persist, that is usually a call to move out of riskier investments. History has many examples of misjudging events as temporary when they were persistent and vice versa. Uncertainties make long-term planning hard, so the general behavior of leaning toward being more cautious when uncertainty is on the rise—as at present—is understandable.
“The dollar weakened as bond yields went up, but the U.S. Treasury market’s liquidity remains unique and unmatched. Whether that will ever change, it’s hard to say, but as of right now there is not an alternative that is competitive.”
Q: Are any of the present issues in the bond market related to the lack of coordination between central banks and their approaches and policies?
Reinhart: There are a couple of ways to address this question. At the moment, the Federal Reserve has held steady on interest rates. Others, like the European Central Bank, have moved interest rates down, and Japan has moved rates upward or, more accurately, inched rates upward. So these policies are not coordinated and are determined by domestic circumstances.
During the COVID-19 shock, for the most part the Central Banks synchronously reduced interest rates. Then, as COVID-19 abated, there was a global inflation spike. Inflation rates rose to 50-year highs in the advanced economies. On that occasion, central banks moved in unison, with the notable exception of Japan. Monetary policy tightened to curb inflation. Because central banks’ interest rates were moving in the same direction, currency markets remained relatively stable. An exception was Japan, where the Bank of Japan kept interest rates on hold. As a result, interest rate spreads widened and the yen depreciated versus the dollar and many other currencies.
Q: Do you see any changes in the U.S. dollar’s role as the global reserve currency?
Reinhart: Following on from the previous question, all of these uncoordinated moves create volatility in currency markets right now. A major factor adding to the volatility recently is the uncertainty of the proposed, implemented, or threatened tariffs and their impact on the United States and the global economy. The tariff debacle has increased the odds of a U.S. recession and higher inflation, which has tended to weaken the dollar.
We are seeing something unique in light of that. Typically, investors flock to the dollar in times of economic stress and higher uncertainty, but not this time.
Q: Then, is the dollar losing its dominance?
Reinhart: In my opinion, the dollar has lost some of its luster, but not its prominence as a reserve currency. The dollar weakened as bond yields went up, but the U.S. Treasury market’s liquidity remains unique and unmatched. Whether that will ever change, it’s hard to say, but as of right now there is not an alternative that is competitive.
There is no bond market version of the euro, as there is no fiscal union and no unified bond market. Investors do not hold euros or dollars, they hold euro assets or dollar assets. The dominant dollar asset is U.S. Treasuries. As for the euro assets, there is not unified bond market, and buying a German bundt is not the same as buying Finnish or Greek debt. This is another way of saying that these are fragmented markets that do not offer the liquidity of U.S. Treasuries.
The renminbi taking the dominant role is doubtful in the short-term but may be possible in the longer term. The issues are different from the ones faced by the euro. A mentor of mine, Rudiger ‘Rudi’ Dornbusch, would say that people will come to the party only when they know they can leave whenever they want. China has extensive capital controls, which are a major obstacle to the use of the renminbi internationally. The dollar’s reserve status importantly owes to the fact that there are no alternatives at this point. That’s why it’s been the dominant currency since World War II and why it has sustained through turbulent times before, such as the 1970’s.
Q: One of the focuses of your research is sovereign debt. What happens when a country cannot repay what they borrowed, and do present events create a greater likelihood of sovereign default? Do you have suggestions as to what a response ought to be or reforms that are needed to respond to situations of default?
Reinhart: Sovereign defaults in low-income countries are, sadly, more likely in recent years. And the consequences of defaults are, perhaps unsurprisingly, not good. Not just in terms of the financial and economic indicators, but the social indicators too. Defaults have real effects on the welfare of the population in countries whose governments have defaulted. In a paper I co-authored with Juan Farah-Yacoub and Clemens Graf von Luckner, “The Social Cost of Sovereign Default,” we go beyond an analysis of the recessionary impact of sovereign default and show the negative social effects that can be quantified. We focus on life expectancy, infant mortality, caloric supplies, and estimates of poverty headcount. We show that during default the social indicators deteriorate and that these effects are significant and lasting.
Defaults are also problematic for creditors, as they don’t get repaid under the conditions in which they agreed to lend in the first place. There are geopolitical issues at play when it comes to debt restructuring, especially when it involves writing off debts. Western economies, including the U.S., have concerns about generating debt relief and new lending that may end up servicing debts owed to China.
Q: Is there a way forward in resolving future sovereign debt crises more quickly?
Reinhart: The first thing that needs to be done is the recognition that a country is facing a solvency rather than liquidity problem. The IMF and World Bank systematically assess a country’s solvency through their debt sustainability analyses. These assessments have been chronically overoptimistic in their economic projections. This inflated outlook may lead to the conclusion that the debt is sustainable when it is not. Misdiagnosing the problem delays its resolution. The second step would be for China to be integrated further with the Paris Club and other multilateral organizations as they become an increasingly large presence in the debt market. So, although debt relief and write-downs are not on the horizon, there can still be steps made toward progress, and there are both profound economic and social reasons to take such steps.
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Photo by Soeren Stache/AP Images.