Sleepwalking into austerity

Bond markets are arguably the least exciting corner of the global economy. They comprise fixed income securities, which are safer as an investment but considerably less financially lucrative.

Government bonds are even less glamorous, official debt instruments issued by countries to make up their revenue-spending gap.

But the lack of glamour here is a good thing. A boring bond market is a sign of good economic and financial health.

The issue is that over the past few months global bond markets have stopped (Opens in new window) being boring (Opens in new window).

We are amidst a major global bond selloff, which has resulted in a sharp rise (Opens in new window) in yields of government bonds across the developed world. From a year ago, the yields on the 10-year government bonds have risen (Opens in new window) by more than 100 basis points across the United States, United Kingdom, Japan, France, South Korea, and Italy. The same period has seen a rise of more than 60 basis points in Australia, Germany, and the Euro zone.

To put it in context, this is the first time since 2007 that the average 10-year bond yield of G7 countries has breached 4%.

As expected, this has been met with some degree of panic. “Long-term sovereign bond yields are now at their highest levels in 15 years or more in most major advanced economies,” notes (Opens in new window) the recent interim report by the Organisation for Economic Cooperation and Development.

There is a slew of reasons (Opens in new window) that explain (Opens in new window) elevated yields. First, a transition to a high and sticky inflation environment owing to regular geopolitical and supply chain shocks. Second, a generational AI-centric investment boom, especially in countries like the US and South Korea. Third, consistent high growth in the United States would translate to higher yields – especially given that the US bonds (treasuries) make up the largest chunk of the global bond market.

On the face of it, these factors don’t necessarily signal a crisis. At most, they indicate the transition of global economy into a new era, and away from the period of “secular stagnation (Opens in new window)”, that was marked by low inflation, low growth, and low interest rates.

However, the next era has the potential to blow up the global economic and financial system. Among financial market participants, there is a growing (Opens in new window) unease (Opens in new window) regarding the idea that the staggering debt levels across the developed world might also be responsible for driving up the yields.

While there is no consensus over the degree to which the exorbitant debt pile is affecting yields, the known fact is that rising yields add to the debt burden of these countries. Today (Opens in new window), the US government pays more in interest payments (Opens in new window) on its outstanding debt annually than it spends on defence (Opens in new window). And the higher the yields go, so does the debt burden.

At this juncture, we might need to take a step back and consider the short- and long-term ramifications of higher bond yields.

In the short term, there are two major causes of concern. First, highly indebted countries might face an actual crisis because of the added debt burden from elevated yields. France and Italy, for instance, might find themselves in an exceptionally tricky (Opens in new window) situation if the yields continue to climb up. Second, given the extremely interconnected nature of the global financial system, a crisis in one country might become a contagion, and spillover into the entire system.

The thing is that the long-term ramification is even more sobering. While the absolute debt-level in some countries like the US is not yet unsustainable, the trajectory is. Given that the average debt-to-GDP in G7 countries (Opens in new window) is over 120% and trending upwards – rising yields mean that over time a large part of the developed world is practically playing with fire.

There is no magical way to get rid of debt. Either a country can grow fast enough and outpace its debt, with some push from good inflation, or raise taxes and cut spending. Here the divergence between countries becomes increasingly glaring. While the US is experiencing rapid growth, Europe isn’t. And even in the US, there is a risk that over time, the rate of debt accumulation would overtake growth. Moreover, given that most countries now feature populists in either the government or as the primary opposition, raising taxes is mostly off the table.

So where does this lead the collective West and its potential options regarding fiscal management? Unfortunately, most of them are increasingly staring at austerity. Cutting spending might be the only credible way for governments to signal fiscal prudence.

In politics, austerity is considered an ugly (Opens in new window) word. After all, the ascendance of populism a decade ago can be attributed (Opens in new window) to the catastrophically mistimed austerity following the 2007–08 global financial crisis – essentially putting aside all the lessons learnt after the Great Depression.

Signs of political anxiety regarding the rising yields and the debt burden are already surfacing. As France gears up for presidential polls next year, the politicians on the far left have suggested (Opens in new window) “cancelling” a chunk of the country’s debt. Cancel is a euphemism for default, and the message is clear: France would rather default than be fiscally sensible.

Regrettably, France doesn’t have that liberty. Today, countries are so enmeshed in the global financial system, and so dependent on it to finance their budgets, that their policy options are practically non-existent. If bond markets are telling politicians to cut spending, then they will have to eventually oblige, or the yields will rise further. Unfortunately, bond vigilantes (Opens in new window) don’t care about the steroidal boost austerity could give an already ascendant populism.