Right around the start of November, two words suddenly disappeared from the chatter in the bond market: debt supply. As bond prices surged across the developed world day after day, sending yields tumbling and handing investors some much-needed profits, the angst about soaring budget deficits melted away.
But for how long?
Over the next several weeks, governments from the US, UK and the eurozone will start flooding the market with bonds at a clip rarely seen before. Saddled with the kind of bloated deficits that were once unthinkable, these countries — along with Japan — will sell a net $2.1 trillion of new bonds to finance their 2024 spending plans, a 7% increase from last year, according to estimates from Bloomberg Intelligence.
With most central banks no longer hoovering up bonds to bolster economic growth, governments must now entice more buy orders out of investors around the world. To do so, the thinking goes, they will have to dangle higher yields, just as they did when concern about ballooning government debt loads was amplified this summer by Fitch Ratings’ move to strip the US of its AAA credit rating. The rout that resulted sent the rate on benchmark 10-year Treasuries above 5% for the first time in 16 years.
Those jitters may have faded of late — primarily because slowing inflation prompted investors to suddenly fixate on the idea that central banks will start cutting interest rates — but many bond-market analysts argue that, given the current supply-and-demand dynamics, it’s only a matter of time before the nervous chatter picks up. Indeed, bond yields have already lurched higher this year and the 10-year rate is now about 4%.
“Right now, the market is just obsessed with the Fed rate cycle,” says Padhraic Garvey, head of global debt and rates strategy at ING Financial Markets. “Once the novelty of that fades away, we’ll start to worry more about the deficit.”
Public debt across advanced economies has soared to more than 112% of GDP from about 75% two decades ago, data from the International Monetary Fund show, as governments ramped up borrowing to finance pandemic stimulus programs, health care and pensions for aging populations and the transition away from fossil fuels.
It’s hard to know exactly how much these soaring debt loads drive up borrowing costs. Researchers at the Bank of England and Harvard University took a stab at it a few years ago. Their joint study concluded that each percentage-point increase in a country’s debt-to-GDP ratio pushes up market rates by 0.35 percentage point.
The math certainly hasn’t worked out that way in recent years. (Treasury yields, for instance, have fallen this century as US debt-to-GDP spiraled higher.)
Imperfections and all, Garvey says the study’s findings should be heeded. With the US now running annual deficits equal to 6 percent of GDP, about double the historical norm, he figures that’ll tack another percentage point onto yields. Not only would that swell the government’s interest tab and deepen the deficit further, creating a vicious cycle of sorts, but it would drive up borrowing costs for companies and consumers and curb economic growth.
Public finances aren’t quite as bleak elsewhere but countries including the UK, Italy and France are all expected to post larger-than-normal deficits again this year. And a plethora of elections will keep those shortfalls in focus; BlackRock Inc. this week warned that Britain’s politicians could spark a selloff in the nation’s bonds if they try to win votes by pledging greater spending.
“It’s difficult,” Garvey says, “to argue that this is inconsequential.”
And yet bond bulls essentially do just that. Steven Major, the head of global fixed-income research at HSBC Holdings, is the loudest of those in this camp. He admits the magnitude of the Treasuries rout that followed the Fitch downgrade took him by surprise, but the episode, which saw the 10-year yield spike 1 percentage point over the course of a couple months, did little to change his view.
Major likes to use an analogy about farmers selling potatoes in a village whenever he’s asked about debt supply concerns. He asserts that an increase in supply, whether it be of potatoes or bunds, doesn’t necessarily have to trigger a drop in the price.
That’s because the demand side of the equation is unknown, he says. There could be more buyers about to show up from the village down the road or from sovereign wealth funds in the Middle East. And in times of recession, which is when deficits become most acute, demand for the safety of government debt tends to pick up.