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Rising government debt and bond markets

Quantitative easing boosted a general inflation. Most central banks want their holdings of bonds to come down – but governments need to borrow more at higher rates.

| 9 min read

In 2020, bond markets did well. Governments in the advanced countries needed to borrow substantially, but central banks decided to institute large buying programmes. They also took official interest rates down to around zero to offset the big negative impact of lockdowns on output and incomes. These very expansionary policies cushioned the lockdown blow and pushed bond prices up to new highs in the middle of the year.

Quantitative easing – or creating central bank money to buy bonds – carried on well into the recovery phase and boosted a general inflation. One of the Federal Reserve (Fed) Governors has now admitted this and expressed some regrets.

In 2022, these same central banks hiked interest rates quickly and severely, running down the bonds they held in their portfolios. This helped push down the price of bonds, creating a nasty bear market in government and corporate paper. The central banks wanted higher long-term interest rates as well as higher short-term rates and wanted to reduce mortgage and other long-term lending. The US ten-year yield hit 4.74% in early January 2023 compared to 0.6% in July 2020.

More recently bond markets have been looking forward to some easing of these bearish forces. In anticipation of falls in official rates to come – and expecting some relaxation of central bank action to reduce their bond holdings as the Fed has recently announced – bonds have picked up a bit from the lows. They now gyrate depending on the inflationary news and on related expectations of how soon and how far the central banks will be able to cut rates. We and others have argued rates would stay higher for longer until central banks were confident inflation was squeezed out of the system.

Quantitative tightening matters too

It is understandable that most commentators concentrate on the central bank inflation outlook and what that means for when official rates will come down, but it is also important to look at what they are doing with their own bond holdings. Most central banks at least want to allow their holdings to come down to some extent as the various bonds they hold fall due for repayment. It is an easier option than selling loss-making holdings directly into the market. It does, however, still cause some stresses in bond markets and for governments.

Whilst the central bank can easily pocket the repayment and decide not to reinvest it in bonds, the government borrowing the money has no such luxury. All the major governments need to borrow again the sums they owe that fall due for repayment, and usually wish to add to their total borrowings by borrowing more additional cash. So called passive quantitative easing, where the bonds run off as they mature, still acts as a brake on bond prices and a limitation on how much a government can afford to borrow.

The debt coming up to roll over includes plenty of bonds issued when interest rates were much lower than today. The government concerned must accept its cost of borrowing goes up every time it replaces an expiring low-interest-rate bond with a higher interest rate one in today’s market. The pace of these changes is therefore also an important issue to look at when working out the supply/demand balance for bonds. Many governments want to borrow more.

US

Under President Joe Biden, the US government has decided to increase its borrowing to pay for a large stimulus package. This has had some success in offsetting the extreme tightening of the Fed but will leave the state with a substantial further large increase in debt that needs financing.

The Congressional Budget Office says that the years 2024-9 will add another $8.7 trillion to a debt that had already hit $26 trillion in 2023. Debt is more than 100% of GDP and scheduled to rise much further over the next five to ten years. Debt interest in May 2024 was running at an annual 16% of total Federal spending. Individual US states also are also putting up their debts, with California at $541bn and New York at $383bn leading the way.

President Biden will wish to continue with spending increases in welfare, health and in promoting his onshoring and green agenda. A second term President Trump would want tax cuts, more military spending and other items, so both main parties will run substantial deficits. As more US debt comes due for refinancing, there will be further increases in interest costs, as the average rate on the debt today at 3% is below current market rates.

The strain of raising large extra sums will also affect the rate at which the money can be borrowed. The US is able to get away with large borrowings as many accept US bonds as good investments, and the central bank can always create money as it did in the regional banking wobble to stabilise the system. However, the fiscal arithmetic is a concern and will become an increasing part of the political debate as some members of Congress point to the need to rein in their less desirable or wasteful expenditures to narrow the borrowing gap.

Japan

The absence of inflation in Japan for most of the last three decades has left the government and central bank free to run an unusual monetary and fiscal policy. The 2023 Japanese Treasury factsheet explained that debt service would account for 22% of general state spending. They pointed out that 31% of the spending would be paid for by bond issues rather than by tax revenues.

This was only possible because interest rates were around zero, meaning the carrying cost of the debt was minimal. The central bank kept buying up more of the bonds in issue, so the government could be assured it could always refinance what it had already borrowed and borrow more for no extra interest cost.

This is gradually being changed. Japanese inflation has edged up a bit, and longer-bond interest rates have been allowed to rise a little. So far, this has gone successfully without spooking markets. It requires further careful handling of the pace of change. The outstanding debt of 1300 trillion yen could become very expensive if Japanese inflation rose too fast and if the country needed interest rates closer to those in other advanced countries.

The European Union

Most European Union (EU) government debts are incurred by the member states and are their responsibility to repay. They are, however, in a shared currency. It is the responsibility of the European Central Bank to create or reduce the amount of money and to fix common official short interest rates for the zone. Member states’ longer rates can vary reflecting different investor views of the credit worthiness of their member state bonds or borrowings.

Post-Covid-19, the EU itself has decided to embark on its own substantial borrowing programme. The Next Generation EU programme requires €712bn, and there will be demands for more money for Ukraine and other purposes. There is talk of bringing in more EU-level taxes to service these rising debts, but each member state has also to act as a guarantor of the union so their larger tax powers stand behind EU debts.

The individual member states have very different levels of debt and additional borrowing. Greece, Italy, Portugal and France are well over 100% of GDP compared to the old limit of 60% set out in EU policy. The EU relaxed its attempted controls on debts and deficits during the Covid-19 pandemic and is now trying to agree tailored programmes for individual countries with excessive debts and deficits.

The state of government indebtedness and the policies of central banks means that we are unlikely to see a return to pre-Covid levels of interest rates.

Ten-year interest rates of more than 4% offer a better rate of return than the flattened rates of the pandemic period. They make sense for some portfolios. The state of government indebtedness and the policies of central banks means that we are unlikely to see a return to pre-Covid levels of interest rates, let alone a return to the low emergency rates of the pandemic.

In each country it is necessary to look at the levels of new borrowing a government wishes to do, as that is a headwind to bond markets. It is also necessary to watch how far and how fast central banks want to slim their bond holdings. They created a great inflation in bonds which they now wish to correct. Decent quality government bonds do best when economies go into recession and inflation disappears. That is not today’s position in most places.

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Rising government debt and bond markets

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Market commentary - May 2024

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