As any analyst will tell you, it’s a mug’s game to predict crashes, but anyone could tell you western markets are facing a tempestuous autumn. And Britain is sitting squarely in the eye of the storm.
Amid weak growth and a worsening budget outlook, British gilt yields are now higher than they have been in nearly 30 years, rising steadily for months and nearly 1% since last year. With national debt of nearly £3 trillion, every percentage point increase in interest drains billions from the government’s budget. Nor is there much hope this will change anytime soon.
Britain’s inflation is proving even harder to dislodge than that of other developed economies, adding a premium to its bonds. To a greater extent than other countries, too, it depends on external creditors for its lending — with 30% of gilts held abroad compared to an average of 18% for other Western countries. Surprisingly, though, investors seem to trust the Chancellor, Rachel Reeves, to keep the books in balance. When there was a hint she might be fired in the spring, the brief bond rebellion showed that investors don’t want her replaced. But they seem to have less faith that she will succeed in getting the economy going again, as evidenced by the fact yields keep rising nonetheless. This means that, as Britain continues to face upward pressure on interest costs, investors are looking to park their money elsewhere.
That certainly seems to be the signal we’re getting from the gold market, where the surging price shows the money is rushing into the one port that, throughout history, has been the safest in a storm. Priced in dollars, gold is up nearly 40% since the start of the year, its surge driven in large measure by central banks shifting out of dollar-based assets as they anticipate a debasement of the US currency.
The chickens of two decades of cheap money are coming home to roost. The World Bank estimates that, over the past 15 years, the global economy has expanded about 67%. At the same time, the world money supply has risen by more than double that, some 145% and rising, at last count. Most of that rise, in turn, was driven by a handful of big central banks — the US Federal Reserve, the European Central Bank, the People’s Bank of China and the Bank of Japan — and the ultra-loose monetary policies which were rolled out following the 2008 financial crisis.
Central banks debased their currencies by increasing the supply of money faster than the supply of goods and services. The purchasing power of money fell. Loose monetary policy would therefore stoke inflation: to beat price rises, people would rush out shopping, which in turn, the theory had it, would stimulate economic recoveries. Meanwhile businesses, with access to cheap credit, would then be able to invest to expand operations.
Things didn’t quite work out that way, though. Instead, asset values soared, driven largely by real estate and cryptocurrencies. (The supply of these assets was relatively fixed, ensuring all that new money bid up a limited amount of assets). But this only made life less affordable for many and so constrained their spending. Economies thus remained sluggish. And try all they might, Western governments still struggle to conjure growth. In the US alone, debt is now rising at twice the rate of the economy. In other words, for all the talk of US exceptionalism, the country has been relying on credit just to keep the lights on.
It is now becoming apparent that what was meant to be a temporary measure risks becoming a permanent one. Despite DOGE, spending cuts and rising revenues from tariffs, the US’s government’s fiscal deficit continues to worsen. As a result, investors, who are losing faith that the world’s leading economies will ever get a handle on their finances, are starting to demand higher interest rates on long-term loans. In all the developed economies, markets are defying the rate-cutting of central banks and driving interest rates higher. Debt is becoming more and more expensive.
The pressure against further borrowing has been building for some time, but three recent developments brought things to a head. First, across the West, inflation has stopped falling and in some major economies, including the US, Japan and Britain, it has now resumed rising. Yet despite this, central banks have continued to ease policy, cutting rates on short-term debt. Now, with the world’s biggest central bank, the Federal Reserve, coming under intense pressure from the Trump administration to slash rates further, analysts are reckoning that we’ll enter a period of “fiscal dominance” — a time in which central banks will subsidise runaway government spending with cheap credit.
Second, amid this loosening of the purse strings, the supply of bonds, which governments sell to raise credit, is rising quickly. Central banks can only control short-term interest rates, since long-term ones are determined by what investors are prepared to offer.
For instance, the government could offer a £100 bond that pays £105 at the end of one year, for a return of 5%. But an investor could offer only £99, raising the effective interest rate above 6%. And if no other investor offers a better price, the government is stuck paying more in interest.
World bond issuance recently reached over $145 trillion, substantially bigger than the world economy, creating a pipeline that is gushing faster than investors can soak it up. Governments are thus being forced to compete with each other to bid up rates and attract funding. It’s become a buyer’s market in which investors, anxious to protect their investments from inflation, are demanding more to lend to governments.
Third, the ageing of Western societies has led to a change in the profile of assets held by pension funds, which account for a large share of global investment. Fund managers were once happy to hold 10- and 30-year bonds on their books, given they didn’t need cash flow while workers were still paying into their accounts. But now, as more of those people retire and begin drawing their pensions, managers are moving to shorter-dated securities, reducing their appetite for long-term bonds.
Amid all this, a less-noticed but equally significant change has taken place over the past couple of decades. There was a time when Western governments were known for their fiscal prudence while developing countries grappled with runaway borrowing, debt crises and hyper-inflation. But that script has flipped. Today, it is the developing world where governments are acting more prudently, and where central banks tack against the wind, keeping credit costs high when governments spend too much.
Add to that the faster economic recovery from the pandemic recessions in much of the developing world, and it’s apparent the world’s investors have attractive new options to choose from. That helps explain why some of the world’s best-performing stock markets this year have been in developing countries — Brazil’s is up over 15% since the start of the year, South Africa’s some 20%, Hong Kong’s (where the Chinese tech sector is concentrated) by over 25%.
But just as significant is what’s happening in bond markets. Because bond yields are much higher in emerging markets, but governments there are behaving more responsibly— developing countries account for a much lower share of world debt than their share of the world economy — what analysts call “yield compression” is underway. Global fund managers, eager to increase their holdings of emerging-market debt, have been bidding up its price, which brings down interest rates. Thus, for example, whereas five years ago South Africa’s ten-year bond paid 9% more than the UK’s, today that gap has been cut nearly in half, to around 5%. Similarly, Brazil’s 10-year bond paid 5% more than the US’s back then, while today that gap is less than 2%. Whereas once the governments of the West had the world’s bond investors largely to themselves, now they’re having to compete with dynamic borrowers in the global south. They’re no longer the prize dogs at the show.
“The chickens of two decades of cheap money are coming home to roost.”
And at the heart of this evolving landscape, in which emerging markets are becoming more attractive than those of the developed economies, lies China. Given the much lower rates of interest on offer there, some borrowers in the developing world have begun to convert their US debts into ‘”dim sum bonds” – renminbi bonds that are issued in Hong Kong. This will further lessen demand for securities in developed markets and drive up the value of the Chinese currency. While use of the renminbi as a reserve asset remains paltry compared to the US dollar and the euro, it is now rising, which will further impede the flow into western bonds.
So in the West, the combination of rising long-term bond yields but falling short-term rates, as central banks cut interest costs, is prompting governments, businesses and households to switch to short-term, variable-rate borrowing. On one hand, that is helping to keep their costs down for now. But on the other, it is loading a huge amount of risk into the system. If inflation were to worsen significantly across the West, central banks would eventually have no choice but to raise interest rates, possibly sharply. Then we could be back to a late 1970s scenario of plunging markets and deep recessions.
That risk may not seem imminent. Inflation today is nowhere near the double-digit levels it reached back then. On the other hand, the direction of travel in Western politics makes it look unlikely anything will arrest the growth of government debt. Governments are unstable – the French one looks set to fall next week, Japan’s is teetering, Germany’s coalition is bickering internally, and in the US, the legendary fund manager Ray Dalio this week warned the country was sliding towards Thirties-style authoritarianism. Even in Britain, whose government has four years to run with a solid majority, the sense that the government is failing to provide direction to the economy is raising concern that the next government will be led by Nigel Farage.
Like Farage, populists everywhere are on the rise. Skilled though they may be at politics and PR, though, few of them, on either Left or Right, have had much luck making their sums add up. This makes it harder to envision future Western governments getting a handle on their spending. Hence long-dated yields will probably continue rising. Ultimately, a point could be reached when the interest on bonds offers more than the dividends from stocks, which could push a sharp rotation out of riskier assets. Why buy the share of a company that pays an annual dividend of, say, 3% when you can buy a better-paying bond from a government which, unlike the business, can never go bankrupt? In other words, all this government borrowing could ultimately crowd out private investment, further slowing the economy.
As autumn draws in, inflation and economic reports will assume considerable importance. Governments and investors will be reading them anxiously, just as they will await with growing concern Rachel Reeves’s next budget. The fact it will be nearly Christmas before we know what’s coming may only raise the temperature in markets, which don’t love ambiguity. What we need is a perfect mix of tame inflation but steady growth. Disappointing results on either front will only worsen the jitters. If, say, inflation keeps rising – and there is every reason to expect it will – a point could come that markets panic.
Will there be a crash? Possibly. Will things get rocky? Almost certainly. Faced with such anxious uncertainty, the one safe bet may be to keep buying gold.