Why the bond markets are sensing trouble

The government bond market is having another of those anxious moments. Such moments occur when interest rates move higher and commentators fall over themselves to explain why. This column inevitably does some of that. Yet what might happen next is infinitely more interesting. It seems unlikely that governments faced with increasingly punishing debt servicing costs will sit idle.

The price of any asset – and a government bond is no different – is a function of the incentives to own it. Governments have more levers than most to pull and, in turn, to influence those incentives in their favour. For investors and savers concerned about government debt levels – a very valid concern – losing sight of those levers can be a costly mistake.

Let us begin with the backdrop. Across the world, there are now multi-decade highs in the cost of servicing government debt. Paying higher interest rates on more than $100 trillion of government debt is a painful evolution for government treasuries. As recently as December 2020, more than $18 trillion of government debt had a negative interest rate. Today, none attracts such a low yield.

Political leaders – of all economic persuasions – have built public sectors around decades of declining interest rates. They are now facing a very different financing backdrop. Left unchecked, this means trillions of extra dollars, pounds, euros and yen spent on interest payments, and therefore unavailable for healthcare, education and defence. Good luck explaining that to an electorate short on patience and long on expectations.

So what is going on? Well, the first thing to note is that quite a lot is going on.

Investors have choices about what they want to own to maximise their returns. One reason there was so much negative-yielding government debt in 2020 was that investors were concerned, with a global pandemic in full swing, that corporate debt and equities might be a dangerous place to park their money. With central banks also buying government debt at an unprecedented pace, there was little concern about finding someone else to sell that debt to should you change your mind.

Such was the enthusiasm – indeed, with hindsight, the hubris – that in June 2020 the Austrian government issued debt for one hundred years at a meagre interest rate of just 0.85%.

But over the last six years, the backdrop has changed. Company earnings have recovered strongly, and earnings per share growth on global stock markets is currently running at three times its long-term average. Inflation has re-emerged as a persistent concern as trade wars have been ignited, energy markets disrupted, and AI-related investment pushed up the prices of building digital infrastructure.

This has meant central banks have been forced to raise rates and sell government debt. The amount of government debt owned by central banks is down from $38 trillion at its peak to $28 trillion today.

To complete the picture, the rapid build-out of the infrastructure that powers the AI economy has meant large US corporates – with much healthier balance sheets than some nation states – have been actively issuing their own debt. In short, government debt faces far more vibrant competition for capital than it did just a few years ago.

There are also ructions in the world's third-largest economy, Japan, where the export of savers' capital to buy higher-yielding debt across the world now risks going into reverse.

Whilst many of these changes to the backdrop for interest rates are welcome developments in how investment is allocated – as the legacy of hyper-low interest rates was often inefficient financing of speculative activity – they are proving a challenge for spendthrift governments.

So are these governments going to sit back and allow the painful financing transition to continue? That appears unlikely.

Just last week, the world's most powerful finance minister, America's Scott Bessent, intervened to buy back long-dated US debt by issuing shorter-dated debt. Long-dated US debt is the instrument most closely tied to the cost of US mortgages.

Earlier in the month, Bessent used the US Treasury's financial firepower to buy Japanese yen, at the cost of selling euros. Given Japan's role in financing the US deficit, this was not a passive currency intervention. It was the world's largest economy – and its largest debtor – feeling the pinch.

It won't be alone. Questioned by journalists in recent days, President Trump called military intervention in the bond market the “ultimate intervention”. For investors, this brings back memories of what has been dubbed the “Mar-a-Lago Accord” – proposals in a paper by former Trump adviser Steve Miran that explicitly tie together US military might with how it might treat its creditors. Should a weaker US Dollar ensue the implications for UK savers are profound given their exposure to Dollar-denominated assets far exceed any other.

In the UK itself, intervention in government debt markets has been rather more subdued, but the signals are there. The new Prime Minister’s economic team have questioned whether the Bank of England's strategy of actively selling UK government debt is appropriate. These calls have been mirrored by Reform UK.

There has been a recent consultation on encouraging retail investors to buy more short-term UK debt, with next steps expected at the upcoming Budget. Speculation around the potential for UK defence bonds, and their post-tax treatment, also speaks to consideration of skewing the incentives towards owning UK government debt. At a time when private pensions are being brought into scope for Inheritance Tax, such a skew could be a powerful feature.

The reason these UK policies are being actively considered is that defined-benefit pension schemes – so long a cornerstone buyer of UK government debt – are drastically reducing their purchases as the UK pensions system becomes more of a defined-contribution system: one less suited to owning large quantities of debt.

All this activity is not without risk. If such cornerstone assets as sovereign debt are going to become political pawns, then the classic risk-free assets don't look quite so risk-free. And if governments incentivise their own cost of capital, the risk is that this comes at the expense of private capital – with a negative impact on private-sector growth and productivity.

Recent moves in assets such as gold and the Swiss franc, alongside a bounce in cryptoassets, speak to concerns about what happens next in debt markets.

The likelihood – based on recent decades of revealed behaviour – is that, when push comes to shove, governments will use policy levers to support their own financing costs. They have plenty of options to do so. The risk is the collateral economic damage this creates. And that is what investors are trying to price in at this moment.