Bonds, specifically of the 30-year variety, have torn up records this year, for all the wrong reasons.
The yield, which moves inversely to prices, on the UK 30-year bond has hovered around a three-decade high of 5.6 per cent, the highest in the G7. German and French yields are at their highest since the eurozone debt crisis 14 years ago. The Japanese equivalent hit a peak in July. US 30-year yields are nearly a whole percentage point steeper annually.
The crucial factor that guides bond investors when deciding which country’s sovereign debt to invest in is whether its economic growth rate will exceed the average rate on its debt. If a government is on the wrong side of that equation, it is in trouble as it is taken as a sign of future default.
With the slowdown in economic growth across developed countries since the 2008 financial crisis and with interest rates steeper after central banks ratcheted them up to deal with the 2022 and 2023 inflation crisis, it is rare to find a country that sits on the right side of that equation.
Deficit spending is everywhere, thrusting yields higher.
France’s deficit, the size of a government’s borrowing to fund spending when taxes are insufficient, last year neared 6 per cent of GDP, although that could drop below 5 per cent if François Bayrou, the prime minister, is able to get spending cuts and tax rises through the French parliament, though that looks impossible.
President Macron’s government is struggling to get spending cuts and tax rises through the French parliament
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Britain’s deficit was about 5 per cent of GDP last year and, after a steady rise in government borrowing costs since March, there is talk of a fiscal hole of up to £40 billion that will require counteracting tax rises at the autumn budget. Sticky inflation, at 3.8 per cent annually in July, has pushed UK borrowing costs higher relative to its peers.
America’s deficit could widen by more than $2 trillion over the next decade owing to tax cuts for the rich under President Trump’s “big beautiful bill”; Germany will embark on a €500 billion borrowing spree, mainly to boost its defence spending. Japan, with a gross debt-to-GDP ratio of more than 200 per cent, has stabilised its public finances for now.
With sustained borrowing amid higher interest rates, better economic growth is needed to ease fiscal tension. Until that happens investors will demand a return, or yield, to hold on to long-term government debt.
Camille de Courcel, head of developed markets rates strategy for Europe at BNP Paribas Markets 360, said: “Rising interest rates, coupled with little appetite to limit spending or increase taxation, have exacerbated fiscal concerns across developed economies.”
Tomasz Wieladek, chief European macro strategist at T Rowe Price, said: “There are concerns in many markets about fiscal sustainability and institutional credibility in many other countries. This is a potentially explosive cocktail for bond markets.”
Friedrich Merz, the German chancellor, is about to oversee a €500 billion borrowing spree, mainly to boost defence spending
DANIEL BOCKWOLDT/GETTY IMAGES
Paul Dales, chief UK economist at Capital Economics, said “ingredients” for a fiscal crisis were in place in a number of big economies, singling out France, Italy and, to a lesser degree, the UK and America.
The other side of the economic ledger, monetary policy, is also putting pressure on long-term government bond markets.
Central banks are reversing their bond-buying programmes, otherwise known as quantitative easing (QE), by selling sovereign debt. The Bank of England has been offloading £100 billion of UK bonds, or gilts, annually but that may change this month when it sets out how much it plans to sell in the coming year. The US Federal Reserve and European Central Bank are also shrinking their balance sheets.
Derek Halpenny, head of research, global markets for EMEA at MUFG, said: “The problem today is that central banks can’t come to the rescue with QE. If QE is deemed unviable by global investors due to inflation then, automatically, fiscal concerns become a greater driver of investor selling.”
Michiel Tukker, senior European rates strategist at ING, said: “As central banks unwind their bond portfolios, markets have significant supply to absorb, pushing up yields.”
Central banks play down that influence. The Bank of England said last month that its bond selling had had a modest impact, raising long-term yields by up to 0.25 percentage points.
When there is greater uncertainty over the direction of the fundamental drivers of an economy — inflation, growth, tariffs, fiscal policy — there is increased uncertainty over the direction of interest rates and a higher chance of economic shocks.
• David Smith: High borrowing costs are a verdict on the UK economy
As such, investors demand a better return on long-term bonds to counteract such near-term economic uncertainty. This extra wedge is called the “term premium”. Short-term bond yields are lower because central banks have been slowly lowering interest rates over the past year.
None of this has been helped by Trump’s efforts to politicise the Federal Reserve with repeated attacks on Jerome Powell, its chair, and the attempted firing of Lisa Cook, a board member at the central bank appointed by President Biden in 2022.
Even so, the blame for the rise in long-term bond yields cannot solely be attributed to policymakers. Big changes in demand for these assets have also reshaped the market.
Central banks no longer act as the linchpin buyer as they did during the era of QE after the financial crisis and during the Covid-19 pandemic. Instead, they are now selling, rather than buying, bonds.
Nor do pension funds. Across developed economies, they have switched from defined benefit (DB) schemes to defined contributions (DC), which buy more stocks than bonds. The Office for Budget Responsibility estimates that about 50 per cent of UK DB pensions funds’ assets are gilts compared with about 7 per cent for DC funds. Life insurers have also pulled back from the market.
These three buyers were price insensitive, meaning that they were, in the main, content to buy long-term bonds regardless of yield.
Capital Economics said: “Pension funds’ weight in domestic government bond markets has generally diminished over time.”
Additionally, buyers that have stepped into the market have not replenished demand sufficiently to keep a lid on yields. Currency reserve funds, private banks and investment funds, the logical replacement purchasers, are more price sensitive, meaning that they will only buy long-term bonds at a higher yield. These institutions also prefer shorter-dated debt.
The arms of governments that deal with bond issuance, such as the UK’s Debt Management Office, have responded to strains in the market by shortening the maturity of the debt they sell.
The bottom line is that higher bond yields are putting pressure on government finances; spending cuts or tax increases may be needed in response.
“That’s why this is a real issue as it could mean households or businesses end up paying higher taxes [but] funding for public services is [still] lower,” Dales of Capital Economics said.
Investors dump French bonds after IMF bailout warning
With the summer drawing to a close, France’s political class and workers are facing up to la rentrée with a sense of of déjà vu as warnings of a fiscal crisis and renewed political instability swirl over the EU’s second largest economy (Mehreen Khan writes).
Eric Lombard, the economy minister, warned last week that the country could need to go to the International Monetary Fund for a bailout to contain the highest budget deficit in the eurozone and a debt pile in excess of 110 per cent of GDP.
His comments came after the country’s borrowing flashed red when François Bayrou, the prime minister, announced a vote of confidence in his pro-austerity government on September 8. Investors dumped French bonds and equities as they bet on Bayrou’s fragile coalition falling, jeopardising his tentative plans to reduce the budget deficit from 5.6 per cent to 3 per cent by the end of the decade.
The prospect of another government collapse, followed by a parliamentary stalemate or new elections, echoes the chaos of last summer when President Macron called a snap vote that led to no party commanding a majority in the country’s National Assembly.
Macron’s shock move shone a spotlight on France’s rising debt burden, which had taken the country’s borrowing premium over Germany to a 12-year high in July last year. Last week the “spread” between French and German ten-year bonds approached similar levels as last year at 0.75 to 0.8 percentage points. This gap could rise as high as 1.25 percentage points if Bayrou’s fall leads to Macron resigning as president, according to analysts at Citi, a US bank.
French government bonds, whose yield rises when prices fall, are now priced to reflect the likelihood of another debt downgrade from ratings agencies this month, George Saravelos at Deutsche Bank said. France also faces the ignominy of having higher borrowing costs than Italy, the eurozone economy most battered by fears of an impending debt crisis. Italy’s ten-year bond yield stands at 3.58 per cent, compared with France’s 3.54 per cent.
Although French borrowing costs are lower than the UK’s, on some measures, investors are pricing in a higher risk premium on French assets. A key measure of market credit risk is the yield curve, which represents the difference between shorter and longer dated bond yields. The gap between 2-year and 30-year debt in France is about 2.3 percentage points, compared with 1.6 percentage points in the UK.
Yet few market analysts expect the latest round of political instability to result in a full-blown buyers’ strike on French bonds. Most expect the European Central Bank to stand ready to buy French assets to quell financial contagion that could spread to other parts of the eurozone.
“The ECB has a lot of firepower to limit excessive widening of eurozone government bond spreads and markets are well aware of this,” analysts at the Dutch bank ING said.