This seems counterintuitive at first. If a government issues debt in its own fiat currency, why can't it always create the money needed to repay it? Technically, it often can. The key is that the risk shifts from outright default to inflation, currency depreciation, and financial instability. Bond investors care about the real value of what they get back, not just whether they get paid.
Here's why yields often spike.
1. Investors care about real returns, not nominal repayment
Suppose you buy a 10-year government bond paying 3%.
If a fiscal crisis makes investors believe inflation will average 8% instead of 2%, that 3% bond suddenly looks terrible.
Even if the government repays every dollar promised, those dollars buy much less.
To compensate, new investors demand much higher yields.
2. Money creation isn't free
A government with monetary sovereignty can finance deficits through central bank purchases (directly or indirectly). But markets ask:
- How much new money will be created?
- Will inflation accelerate?
- Will the currency lose value?
- Will the central bank remain independent?
If investors expect substantial monetization, they demand higher interest rates immediately.
3. Currency depreciation hurts many investors
Many sovereign bonds are owned by foreign investors.
Imagine you're a European investor buying U.S. Treasury bonds.
You earn dollars. If the dollar falls 20% against the euro, your investment may lose money even if the Treasury pays every coupon.
If markets expect a weakening currency during a fiscal crisis, foreign investors require higher yields as compensation.
4. Inflation risk premium rises
Bond yields can be thought of roughly as:
Real interest rate + expected inflation + risk premium
During a fiscal crisis:
- expected inflation rises
- uncertainty rises
- liquidity may worsen
- political risk increases
Every component except perhaps the real rate tends to increase.
5. Central bank credibility matters
Countries with highly credible central banks often experience much smaller yield increases.
For example, markets generally believe that the Federal Reserve System or the Bank of England will eventually tighten policy if inflation becomes excessive.
If investors lose confidence in that commitment, yields can rise sharply.
6. Governments may choose not to monetize
Printing money is politically and economically costly.
Large inflation can:
- damage household purchasing power
- destabilize the banking system
- reduce investment
- create social unrest
Markets know governments often prefer fiscal adjustment over runaway inflation. During uncertainty about which path policymakers will take, investors demand a higher return.
7. There is also rollover risk
Governments rarely repay all debt at maturity from tax revenues. Instead, they refinance by issuing new bonds.
If investors become reluctant to buy new debt unless yields are much higher, borrowing costs jump.
Even a government that cannot technically become insolvent in its own currency can face severe financing stress because refinancing becomes extremely expensive.
Why Japan is the famous exception
Japan has government debt exceeding 250% of GDP, yet its bond yields have often remained relatively low.
Several factors help explain this:
- Most debt has historically been held domestically.
- Inflation was low for decades.
- The Bank of Japan has aggressively purchased government bonds.
- Investors have generally viewed Japan's institutions as stable and credible.
This illustrates that high debt alone doesn't determine yields. Expectations about inflation, monetary policy, and institutional credibility are just as important.
The key insight
When debt is denominated in a country's own fiat currency, investors usually don't worry primarily about "Will I be paid?" Instead, they worry about "What will my repayment be worth?"
A fiscal crisis raises fears that repayment will come through some combination of:
- higher inflation,
- currency depreciation,
- financial repression (keeping interest rates artificially low),
- or broader economic instability.
Those risks reduce the attractiveness of existing bonds, causing their prices to fall. Since bond prices and yields move inversely, yields spike—even when nominal default remains unlikely.
