When you see bond yields start climbing, what exactly is the first thing that comes to mind? Interest rates? Inflation? Risk aversion? I can certainly bet that it isn’t your next trip to the supermarket.
After all, what exactly do 10-year bond yields have to do with the price of groceries? Well, perhaps more than you might think.
Let’s take an example of a government that needs to borrow $100 billion to finance its spending. They have to pay an interest rate of 3%, so that works out to $3 billion in annual interest payments in theory. That sounds simple enough, no?
But what happens if the same government has to then borrow the same amount at 5% interest? The bill suddenly rises to $5 billion instead. That is an extra $2 billion a year just to service the same amount of debt.
Now, governments don’t have unlimited money to spend. What they do is that they collect taxes and borrow from investors, then decide on how to allocate those funds across everything from healthcare to infrastructure and public services.
So when more money actually has to go towards interest payments, something has got to give on the other side of the equation.
That is when we see the political playbook gets opened up and we get things like higher consumption taxes, which directly increase what shoppers pay at the checkout. Or perhaps even higher corporate taxes, with some businesses choosing to pass part of those costs on to customers.
The other alternative is that the government might also cut spending or pull back on subsidies. Just picture a government that has previously helped keep electricity or fuel prices affordable. All of a sudden, those subsidies are reduced and households now could be facing higher bills while businesses might pass down some of their higher operating costs to consumers as well.
All of those scenarios underscore the notion that what started as a problem in the bond market has now found its way into your shopping basket.
Having said that, it is important to be reminded of the fact that higher borrowing costs don’t automatically mean higher inflation.
If governments respond by cutting spending or raising income taxes instead, then households may have less money to spend as a whole. That could actually weaken demand and ease inflation rather than push prices higher.
At the same time, higher bond yields don’t immediately increase interest payments on all existing government debt either. The impact tends to feed in more gradually as old debt matures and governments refinance at higher rates.
In any case, the bigger takeaway is that when bond yields rise, someone eventually has to foot the bill. And whether that is through higher prices, higher taxes or subsidy cuts, the cost can eventually find its way back to you and your shopping basket.
This article was written by Justin Low at investinglive.com.