The global economy is at an odd juncture, one that points to an ugly few years for bond markets.
The fiscal picture across developed economies is deteriorating rapidly and uniformly, yet unlike previous bouts of huge government spending in the last two decades, there is no global financial crisis or pandemic requiring trillions of dollars.
Far from it. Growth appears solid, an unprecedented private sector capex boom is underway courtesy of the artificial intelligence arms race, and stock markets are at record highs. All these dynamics are clearly feeding off each other.
Governments are loosening their purse strings because they are adjusting to a new world reality: Globalization is fraying – or, some might say, dying - and being replaced by polarization, isolationism, and rising geopolitical tensions.
Promises to ramp up spending on defence, energy and resource security, and technological advancements – alongside pledges to help voters with affordability issues – threaten to put enormous strain on public finances that have never fully recovered from the Covid-19 pandemic.
In the United States, President Donald Trump has called for the defense budget to be increased by 50 per cent to US$1.5-trillion, which would dramatically widen a budget deficit already hovering around 6 per cent of GDP. Meanwhile, Germany has removed its ‘debt brake’, and new borrowing this year for defence and other expenditures will be close to 200 billion euros.
Then there is Japan. Prime Minister Sanae Takaichi – whose Liberal Democratic Party won a landslide election victory on Sunday – is promising huge spending increases and tax cuts to boost Japan’s economy as well as its military and energy security. A bumper US$117-billion supplementary budget to fund this will mostly be financed through new debt issuance.
With debt loads, deficits and yield curves rising everywhere, market indigestion could set in alongside increasing anxiety, with bond investors requiring ever more yield to absorb so much paper.
Importantly, central banks can no longer be depended on to pick up the slack. Kevin Warsh, Trump’s pick to replace Jerome Powell as Federal Reserve Chair, says the Fed should reduce its balance sheet. The Bank of England and European Central Bank are also shrinking theirs. Even the Bank of Japan has been scaling back its bond purchases since 2024, and may not be keen to bail out Takaichi’s administration should yields shoot up.
Governments are trying to ease the strain by issuing more short-term bills and shortening the maturity of the debt profile. This helps cap borrowing costs and limits investors’ ’duration’ risk, but it increases ‘rollover’ risk of regularly refinancing maturing debt.
The hope is the extra borrowing spurs sufficient growth to stabilize debt-to-GDP ratios and ensure the debt is sustainable, because it doesn’t look like fiscal discipline is on the horizon.
“Unless a pick-up in nominal growth drives higher incomes and tax revenues – AI investment and/or productivity per se might not be enough – some countries might face tough consolidation challenges,” HSBC analysts wrote last week.
The consolidation needed would be large. With borrowing costs at current levels, HSBC estimates that the U.S. would need a fiscal adjustment of over 4 per cent of GDP to stabilize its debt-to-GDP ratio, with 3 per cent required by France, and 2 per cent by the UK and Germany.
Consolidations of such scale are rare. In major advanced economies since 1990, there have been only eight of over 4 per cent of GDP during a 5-year period, with fifteen over 3 per cent of GDP in that timeframe.
Whether all this fiscal expansion ends in currency debasement, hyperinflation and crashing bond markets is a separate debate. But even if these doomsday scenarios fail to play out, it’s fair to assume that bond markets will be under pressure moving forward.
This all suggests that in today’s fractured new world, the 40 per cent slice of a traditional ‘60/40 equity/bond’ portfolio looks increasingly fragile. Investing is always a relative decision, but the question for fixed income investors may increasingly become, what is the least unattractive option?