Governments brace for fiscal reckoning from bond markets

Investors are warning governments to expect much higher borrowing costs over the coming years, in a shift that will pinch public finances and constrain states’ ability to respond to crises.

Despite a recent rally, government bond prices have dropped hard on both sides of the Atlantic this year, in part reflecting a growing acceptance that interest rates will need to stay high for the long haul to dampen inflation. In addition, investors are struggling to digest governments’ much bigger debt issuance plans without central banks stepping in to hoover up supply.

The result is much higher bond yields that tie governments in to large regular interest payments when they take on fresh debt. In 2018, the interest bill for G7 countries stood at $905bn a year, according to credit rating agency S&P. By 2026 it will be $1.5tn.

“Investors have always worried about government debt and it’s never been a problem, but this time it feels like it’s for real,” said Jim Leaviss, chief investment officer of public fixed income at M&G Investments.

“We’re not just worried about the amount of government borrowing for normal stuff like healthcare spending and pensions,” he said. Instead, he is worried about “structural” issues such as the size of debt interest payments, the impact of central banks shrinking their own bond holdings and the huge 31 per cent slice of US government bonds that will need to be refinanced next year.

The yield on benchmark US Treasuries has risen by about 3 percentage points in the past two years to roughly 4.5 per cent, and last month it rose above 5 per cent. Economists surveyed by Bloomberg now expect those 10-year bonds will yield about 4.5 per cent at the end of 2025, up from previous expectations of 3.5 per cent at the beginning of July.

Elevated debt levels were at the forefront of conversations at the annual IMF and World Bank meetings in Marrakech last month, with the head of fiscal affairs at the Fund, Vitor Gaspar, telling the Financial Times that rising debt servicing costs for governments would be a “persistent trend” over the medium term and have a “lasting effect”.

Over decades, investors and governments have become accustomed to a fairly reliable pattern in interest rates. Typically, central banks push them up to hose down inflation, but quickly cut them again when economies slow down.

Now, it is becoming increasingly clear that a return to the post-2008 era of interest rates close to zero per cent is unlikely. The longer-term outlook for rates is highly contested, but factors that could keep them up include high levels of public borrowing including huge investment in projects such as the green transition and infrastructure.

In addition, central banks are no longer stepping in to keep borrowing costs down by buying bonds in quantitative easing programmes; instead they are reducing the size of their balance sheets through quantitative tightening.

“We are basically transitioning from markets that were engineered by central banks through QE to markets that are less engineered by central banks because they are now doing QT, and at the same time there’s a lot more fiscal activism so there’s a lot more issuance and the market needs to absorb that,” said Guillermo Felices, global investment strategist at PGIM Fixed Income.

“We have left that era [of zero rates] behind us,” said Stephen Millard, a deputy director of the National Institute of Economic and Social Research in London. 

The IMF says global public debt is on course to approach 100 per cent of gross domestic product by the end of the current decade. Among the biggest drivers is the US, where the government deficit is on track to exceed 8 per cent of the country’s GDP this year.

“Something must give to balance the fiscal equation,” the IMF warned about global debts. “Policy ambitions may be scaled down or political red lines on taxation moved if financial stability is to prevail.”

The US, which has the highest central bank rate in the G7 and a low revenue base compared with its higher-tax peers, is on course for a dramatic surge in debt servicing costs. Bill Foster, senior vice-president at rating agency Moody’s, estimates that US interest expenses as a proportion of government revenue will jump from under 10 per cent in 2022 to 27 per cent by 2033.

The expected jump in interest payments is more acute in the US than in some other countries because of the amount of Treasury bonds that will need to be rolled over in 2024, which is likely to lead to significantly higher government interest payments. Congressional Budget Office forecasts suggest that net interest spending will be close to half of America’s overall deficit by 2026.

Investors doubt whether the US can grow its way to a lower debt burden. Economic growth forecasts for next year are anaemic at just 1.5 per cent, whereas benchmark inflation-adjusted yields stand at close to 2.2 per cent. “That is essentially telling you that there might be a problem going forward if interest rates stay this high,” said Felices.

“If the market smells that fiscal sustainability is under threat then they will push governments to some sort of adjustment . . . by demanding a higher risk premium to own their debt,” he added.

A deluge of new debt hitting markets is also weighing on bond prices, particularly in the US. The Treasury market is roughly $25tn in size today, five times what it was in 2008.

“The market is thinking, hang on a minute, there is absolutely no appetite or visibility on any fiscal belt tightening at any point in the near future,” said Rohan Khanna, head of euro rates strategy at Barclays. In fact, spending might be expected to grow with elections coming up in the US, Germany, France and the UK next year, Khanna added.

The uncertain outlook is also putting some investors off owning long-dated bonds, given the risks that geopolitical tensions will lead to greater military spending and higher costs of relocating strategic industries.

“Governments have to realise that the uncertainty about the long-term rates has just blown up [increased a lot],” said Tomasz Wieladek, chief European economist at asset manager T Rowe Price. “They will have to be more prudent going forwards as there are risks that the debt servicing becomes unmanageable.”

Policymakers have at least sounded more cautious about America’s mounting obligations now that it boasts a debt-to-GDP ratio of roughly 98 per cent. Jay Powell, chair of the Federal Reserve, was the latest official to raise concerns about the US fiscal situation.

“It’s not that the level of the debt is unsustainable,” he said in October. “It’s that the path we’re on is unsustainable and we’ll have to get off that path sooner rather than later.” 

Europe is also grappling with surging debt costs, with fiscal concerns helping to push up borrowing costs across the region. The UK was given a warning shot last year when former chancellor Kwasi Kwarteng announced a £45bn package of unfunded tax cuts, sparking turmoil in the bond market and leading to intervention by the Bank of England. 

The UK has also experienced a sharp rise in interest costs, given that around 25 per cent of its debt is in inflation-linked bonds. Debt interest spending reached 4.4 per cent of national income in the most recent fiscal year in the UK, more than double the average of 2 per cent over the first two decades of this century. 

According to the Institute for Fiscal Studies think-tank, it will stay at or above 3 per cent of GDP over the medium term, £26bn a year higher than previous levels. Rating agency Fitch estimates interest costs will be 10.4 per cent of government revenues this year, up from an average of 6.2 per cent between 2017 and 2021. 

In the EU, several countries have a budget deficit higher than the bloc’s 3 per cent limit, which is set to become effective from January after it was suspended during the pandemic.

Concerns are also mounting in Italy. The gap between benchmark Italian and German borrowing costs surged by 0.3 percentage points to more than 2 per cent after Prime Minister Giorgia Meloni’s government raised its fiscal deficit targets and cut its growth forecast for this year and next. However, it has since narrowed again as part of a wider bond market rally.

“Deficits are why people talk about bond vigilantes coming back — the idea that bond markets will act as a constraint on fiscal spending,” Leaviss said.