Central banks can brush aside rising long bond yields

As it cut rates to 2 per cent last Thursday, the European Central Bank said it was in a “good position” to navigate the uncertain conditions facing it in the months ahead. Donald Trump later complained that the Federal Reserve was not as well placed to deal with whatever policy whims took his liking. The Fed will ignore his latest gripe.

Much harder to cast aside has been the sharp rise in long bond yields in many advanced economies. Yields have risen to their highest levels in decades in Japan and the UK. The US and Japanese governments have at times struggled to sell long-term debt. And while US bond yields have been rising the dollar has declined, suggesting some element of investor resistance to US assets.

Scary charts like the ones below can be found in numerous articles and analyst notes.

Are these movements in government borrowing costs reflective of the amusingly named One Big Beautiful Bill Act that has passed in the US House of Representatives? Is it spooking investors as well as former government adviser Elon Musk? Is other countries’ debt being tainted by contagion risk from a US where fiscal policy is going off the rails? Is this all just a normalisation after an aberrant period of unusually low government bond yields? Gillian Tett, Sushil Wadhwani, Kenneth Rogoff and Martin Wolf respectively wrote these FT articles and they are all worth your time.

No one can be confident yet about the answers. Reasoning from price changes is always dangerous. So, I am going to ask a simpler question: what should central bankers do about rising long bond yields, if anything?

Go on then, what?

The qualifier “if anything” is important because central banks’ main policy instrument is the short-term interest rate, which has waning influence as the time horizon extends.

Of course, quantitative easing was designed to lower longer-term interest rates by creating money and adding to demand for longer-dated government bonds, so the net effects of central banks’ balance sheet policies matter. But the default thinking should be that investor demand governs the long end of the government bond yield curve, while monetary policy controls the short end. Movements in long bond yields tell us important things about investor sentiment, and we mess around with that at our peril unless we are in an economic crisis.

There are, nevertheless, reasons an inflation-targeting central bank should get involved and worried by rises in long-dated government bond yields. The main one would be if investor reticence suggested a lack of confidence in central banks’ ability to control inflation. We can examine this by looking at the difference between nominal bond yields and inflation-linked bonds of the same duration, showing the market expectation of future inflation over different time horizons.

The chart below shows these inflation break-evens for the US, UK, Germany, France and Japan, and there is clearly no problem. Investors are not currently concerned that inflation will be the default mechanism governments use to erode their debt. The expected inflation levels differ by country, but this is mostly the result of a gap between the price index used in inflation-linked bonds and the measure targeted by central banks.

Happily, we can therefore disregard the argument that central banks have lost credibility as a reason for the recent change in yields.

A second worry we can also probably put to bed is that long bond yields are rising as a result of contagion from the US. The correlations between bond yields in different countries is not that tight. Long-term German Bund yields, for example, rose in March as Friedrich Merz’s Christian Democratic Union declared victory in the federal election and investors anticipated big spending increases on defence and infrastructure. Japanese yields rose because life insurance companies stopped buying long-term bonds after meeting domestic solvency rules. (For more on this, read my colleague Andrew Whiffin’s article on FT Monetary Policy Radar.)

As the chart below shows, the correlation of bond yield movements has been far from perfect at the short and long end. Since Trump’s inauguration, bond yields have been flat or falling in Europe and the US, up to the 10-year horizon, and have risen in Japan, mostly reflecting expected interest rate changes. They have risen at the 30-year horizon everywhere, but the moves are objectively small.

If you click on the chart to look at the moves since “liberation day”, the US is a natural outlier, with rises in yields across all maturities. Eurozone 30-year yields have declined.

No one should talk confidently about spillovers from the US. Central banks should not use that as justification for rate cuts.

A third reason for central banks to act would be to ease financial conditions that might have become tighter with the rise in long bond yields. Be careful here. US financial conditions, measured by the Chicago Fed, did tighten after “liberation day” but have eased since. ECB President Christine Lagarde said last Thursday that they had similarly loosened in Europe, generating higher equity prices, lower corporate bond spreads and lower corporate interest rates.

In the UK, Bank of England deputy governor for financial stability Sarah Breedon told parliament that the phenomenon of rising long bond rates “does not much matter from a monetary policy perspective” because “the rates that matter for businesses and households are at the shorter end”.

She is absolutely correct. Although her view raises awkward questions about why the BoE risked and lost many billions of pounds buying huge long-dated bonds in its quantitative easing programme on something that “does not much matter” for the UK economy. In a speech last week, external Monetary Policy Committee member Catherine Mann warned that it was, in any case, very difficult for the BoE to surgically offset any rise in long-bond yields with cuts in short-term interest rates.

Should central banks do nothing?

As long as there are few concerns about financial stability, the answer is generally “yes”, they should do nothing.

This is primarily a fiscal problem. Partly because long bonds are out of fashion, and partly because pension funds do not need as many new long-term assets as their schemes mature, demand for long bonds has fallen. Unfortunately for governments, it comes at a time when they want to issue a lot of new debt.

Central banks might sensibly tweak their quantitative tightening programmes to sell a little less long-dated debt, but the BoE is the only central bank in this business and the numbers are small.

Instead, if governments want to see lower borrowing costs for long-term debt, they will need to rein in fiscal deficits. They might also seek to issue less long-term debt in the meantime until there is more confidence in the public finances.

The UK is doing just this, with the country’s Debt Management Office halving the quantity of long-dated bonds it issues in 2025-26 compared with the previous financial year. In Japan, the rise in yields has been softened by a government consultation on whether it should trim issuance. And in the US, Treasury secretary Scott Bessent has gone rather quiet on his previous insistence that US government debt was too short-term.

These are temporary measures. The permanent fix of more resilient public finances is still some way off.

What I’ve been reading and watching

• Lagarde gave short shrift to questions regarding her future at the ECB last week, saying “you’re not about to see the back of me” because “I’m determined to complete my term” (30 mins 40 secs).

• The Russian central bank has cut rates by one percentage point to 20 per cent as inflation dipped below 10 per cent. It’s economy is losing momentum.

• St Louis Fed President Alberto Musalem told the FT there was a 50-50 chance that US tariffs would provoke persistent inflation.

• IMF deputy managing director Gita Gopinath said Trump’s trade wars posed a greater challenge to central banks in emerging economies than the pandemic.

A chart that matters

The ECB produced its own economic scenarios along with a central projection last Thursday. I have reverse engineered the published figures to present stylistic versions of its severe and mild trade scenarios for GDP growth, superimposed on the central bank’s main projection and its normal forecast errors.

The scenarios do not diverge massively from the central forecast, but they do so more than those of the BoE in May. The predictions are plausible. The severe trade scenario involves an immediate mild recession before a recovery with permanent damage done. The mild trade outcome shows better growth outcomes are sustainable if trade barriers fall.

I am still not sure what purpose these scenarios serve apart from saying that the world is worse with bad economic policy and better with good economic policy. We knew that.

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Central Banks is edited by Harvey Nriapia