Bigger debt loads and erratic politics haunt bond markets
There is anxiety about the fiscal path as governments are squeezed by high interest costs and elections cast uncertainty
THE bond-market tremors came two weeks and two continents apart.
The first was in mid-June, when French President Emmanuel Macron’s decision to call a surprise election triggered a selloff amid fears a new government would ramp up spending. Then Treasury yields jumped after Donald Trump trounced Joe Biden in the presidential debate, fanning concerns that the US deficit would surge if the tax-cutting Republican returns to the White House – a trade that flared again early last week after the assassination attempt rallied supporters around his candidacy.
Another twist came on Sunday (Jul 21), when Biden announced that he was no longer seeking the Democratic Party’s nomination, and endorsed Vice-President Kamala Harris.
The moves drew little notice beyond financial circles, and they were soon overshadowed as speculation about coming interest-rate cuts moved back to centre stage. But they amounted to early warning signs of the global risk posed by the combination of surging government debt loads and increasingly unpredictable election-year politics.
Even as the world’s economy expands at a solid pace, deficits have piled up thanks to heavy spending in the wake of the pandemic. As a result, the amount of government debt from major nations is seen swelling by US$2 trillion this year to a record US$56 trillion, according to the OECD. The debt loads are expected to keep edging up across the developed world – a trend that the International Monetary Fund warned last week could be worsened if newly elected governments boost spending to support politically popular programs.
“Politicians will attempt to further delay the inevitable course correction,” said Christoph Rieger, the head of rates research at Commerzbank. “Some countries may test how far they can go until their debt ratio reaches a critical point.”
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The fiscal strains are threatening to test markets’ ability to absorb an ever-increasing amount of debt without driving rates higher. As a result, investment firms such as BlackRock have been favouring shorter-term bonds, which are less likely to be dragged down by angst surrounding problems in the years ahead.
There’s been no shortage of fiscal alarmists over the years, of course, and the idea that so-called bond vigilantes will punish spendthrift governments has arisen periodically, only to fade into the background again whenever crises failed to materialise. Right now, worries about deficits have largely been swept aside by speculation that borrowing costs are heading lower.
Yet beneath the surface, there’s anxiety about the fiscal path as governments are squeezed by high interest costs and elections cast uncertainty.
Last week, the IMF warned that incoming politicians may orchestrate “significant swings” in policy that “entail fiscal profligacy risks”. The Bank for International Settlements has said governments are becoming increasingly vulnerable to a loss of investor confidence. Rating companies have also expressed concern.
“In some parts of the world, it’s not the level of debt – it’s the perception of the framework around it,” said Jean Boivin, head of the BlackRock Investment Institute. “The range of political outcomes that can come this year is as wide as it can get.”
That was on display last month, when Mexico handed a larger-than-expected victory to President-elect Claudia Sheinbaum and her Morena party. The results triggered a selloff across Mexican markets on jitters that she’d push initiatives through Congress that would worsen the deficit.
The following week, Macron dissolved France’s parliament and called a snap vote. Fears of a victory for Marine Le Pen’s far-right National Rally pushed French bond yields to their highest against German debt in more than a decade. They remained elevated after a split vote left Macron wrestling to build a coalition government, threatening his ability to enact fiscal reforms.
European Central Bank president Christine Lagarde last week stressed the importance of adhering to the bloc’s fiscal rules, which have been breached by France, Italy and a clutch of smaller economies.
The Trump trade
In the US, where the deficit is already approaching US$2 trillion, the election is underscoring those risks.
While the national debt has swelled under Biden, Trump’s plans to extend his tax cuts would almost certainly add to it. Both Vanguard Group and Fidelity International have said a Republican sweep in November would pose the greatest risk to bonds by expanding Trump’s ability to implement his agenda, some of which is also expected to contribute to higher inflation.
After the assassination attempt gave added momentum to Trump’s candidacy, long-term bonds slid early last week as investors ploughed into wagers that the yield curve would steepen. That briefly put 30-year yields at the same level as two-year ones for the first time since January, erasing the inversion in that part of the curve.
“The higher the likelihood of Donald Trump becoming the next US president, the higher-for-longer the US budget deficit will be,” said Alex Pelteshki, fixed-income investment manager at Aegon Asset Management.
It’s possible that borrowing can go on for some time without a crisis and that the latest round of fiscal hand-wringing will also recede. Japan, for example, has seen little fallout as its debt-to-gross-domestic-product has climbed to about 250 per cent, propped up by its central bank’s vast quantitative easing program for more than two decades.
But the UK offers a cautionary tale. Former prime minister Liz Truss was quickly pushed out of office after her plans for large unfunded tax cuts in 2022 sent government bond yields surging as investors dumped the securities.
It was a stark lesson in how quickly markets can turn on profligate governments. The episode loomed over the country’s recent election, with the new leaders putting economic stability as a top priority.
“Investors know exactly what they dislike,” said Benoit Anne, a managing director at MFS Investment Management. “They dislike political uncertainty and instability, increasing fiscal risks and policy credibility shocks.” BLOOMBERG
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