Global government bonds are deteriorating fast: “it ain’t looking good!”
Global bond yields have been increasing in most developed market countries since the US-Iranian war began, reflecting – at least initially – rising long-term inflation expectations as oil prices skyrocketed. However, there is much more to the ongoing weakness in government bonds around the world. In addition to being worried about ongoing elevated inflation, investors are clearly concerned about the deteriorating fiscal condition of many countries, especially the UK, France and the US. These concerns mean that investors need to be paid more to take on government bond risk, and this is driving yields higher.
The European “problem children”: the UK and France
In Europe, investors are showing growing concerns with deteriorating public finances in both the UK and France.
The United Kingdom
The UK has virtually no room to manoeuvre as far as fiscal flexibility. With the autumn budget scheduled to be presented to Parliament at the end of the month and almost no fiscal headroom, there is little that PM Andrew Burnham’s Labour government can do to stimulate much-needed economic growth, at least in the short-term. Investors are increasingly showing their concerns, with the yield on the 30y Gilt increasing to 6% last week, the highest yield since 1998.
As in the past, bond vigilantes will force the Labour government to toe a narrow line. With the country continuing to suffer from oil-induced high inflation, the Bank of England is unlikely to help, and might even raise its policy rate at its next monetary policy meeting.
From my vantage point, the UK looks like it is in a real pickle at the moment. The only good news is that economic issues in the UK are largely (although not completely) confined to that market, at least for now.
France
France is an entirely different matter altogether. The common currency bloc (the Euro in the Eurozone) represents a much larger and more diverse economy than the UK, with a deeper currency market and a bond market that is far more international (than the UK Gilt market).
There is general agreement that the French government faces a monumental hurdle to develop a politically acceptable gameplan to reverse its debt-financed spending binge. France has traditionally blown through the 3% annual deficit requirement of Euro members year-after-year. The country has not had a balanced budget since 1973, and structural deficits recently have been running around 5%/annum.
Numerous factors have contributed to this, but one key element is high structural welfare costs (i.e. social spending), which at 57.5% of the annual budget is the highest in the Eurozone (see IMF report here for more).
Do you remember the countries that comprised “core Europe” during the Euro crisis that started just after the GFC in 2009? The core included Germany and France, the two largest and strongest economies in the Eurozone. Oh, how times have changed! If you measure strength by looking at government bond yields, France is now at the bottom of the barrel as far as Eurozone countries, about as far from “core” as one can imagine. The yield on the 10y French OAT (government bond) closed Friday at 4.92%, 147bps higher than the yield on the Eurozone’s “gold standard” of government bonds – the 10y German Bund (closed 3.45%). The table below depicts yields at the close on Friday on Eurozone member countries. It is not pretty reading for holders of French government bonds (OATs).
France also will get no help from the ECB, since monetary policy in the common currency bloc will remain restrictive due to elevated inflation. In order to restore investor confidence, the French government will have to make a series of difficult political choices around spending that simply do not sound feasible given the turmoil that has characterised French politics over the last several years.
Ultimately, a solution will involve economic pain. Drastic measures involving belt-tightening will be required to put France back on the right track in order to restore investor confidence. Failure to rein in spending and increase revenues (through higher taxes) will inevitably lead to ongoing deterioration in France’s fiscal situation. And should this continue, it could easily lead to contagion into other Eurozone countries, one reason perhaps the Euro has been weakening even though the ECB rhetoric is arguably the most hawkish of any of the G7 central banks.
Assuming bond investors increasingly shun France, and the government lacks the cohesion and political will to formulate a viable plan, the involvement of the IMF cannot be ruled out. This might sound far-fetched, but it is not out of the realm of possibility. France was the first country in fact to use the IMF during a financial crisis (in 1947). The country is no stranger to leaning on the IMF for solutions, having involved the IMF four times in the past, the most recent being in 1969.
As far as IMF precedents for other developed economies, the UK had to go to the IMF in 1976, South Korea had to go in 1997, Iceland had to involve the IMF in 2009, and several of the “PIIGS countries” needed the IMF to assist in restructuring their finances during the Euro crisis. Although it might seem far-fetched, there might be no alternative except to involve the IMF if the French government fails to develop a viable plan, and bond investors “go on strike”.
Conclusion regarding the UK and France
I suppose the good news with France is there is plenty of room for the government to cut social programmes, in that 57.5% of the budget goes to welfare costs (as mentioned earlier). The similar figure for the UK is 33% of government spending that is for welfare costs. The US figure is 28% to 30% when including social security and Medicare, comparable to the figures as presented for France and the UK. I suppose saying the French government has more manoeuvrability is analogous to a seeing a glass as half empty or half full – the government still has to develop the will to implement a viable plan to reduce welfare costs, not an easy ask in a country like France.
I shudder at the thought of the UK or France digging themselves an even deeper hole, although I suspect the Brits will “muddle through” (because they usually do). France though remains a big concern and investors will shun their bonds until the government can demonstrate a plan to rein in deficits and curtail spending. The situation involving France could get ugly fast.
The US gets by with fiscal murder…for now at least
Discussions about the UK and France make you appreciate the fact that US politicians are able and willing to destroy the fiscal integrity of the world’s largest country without getting severely punished, although I suspect that this will almost certainly end at some point. Currently, investors are seeking higher yields for what they perceive as a deteriorating US fiscal situation. The yield on the 10y US Treasury bond closed October 2nd at 5.28%, and the yield reached the highest intraday level last week (5.35% on Thursday) since 2002.
It is fortunate that the US has the world’s most-used global reserve currency (the US Dollar), and has by far the largest and most liquid government bond market in the world. According to SIFMA, outstanding US bonds totalled $31.8 trillion at the end of September. Around the same time, UK government bonds outstanding totalled circa £2.5 trillion ($3.25 trillion equiv.), and French government bonds totalled circa €2.9 trillion ($3.2 trillion equiv.). The UK and French government bond markets are roughly 10% the size of the gigantic US Treasury bond market, which is still seen as the ultimate risk-free investment.
Having said this, it is very concerning to see interest on ballooning U.S. debt soaring to $1 trillion per year, accounting for nearly $1 out of every $5 in tax receipts. This is larger than what is spent by the US on national defence, the largest discretionary component of the budget. The interest burden is expected to worsen in the years ahead.
Without a gun to their heads, the current president and Congress have no interest at all in looking at solutions for the worsening US debt situation. This is a very different situation than in the UK and France, at least for now, with the latter two countries having no choice now but to address their issues as bond vigilantes force their hands. The US has become very good at kicking the can down the road, essentially saddling future generations with the debt that has accumulated through the ongoing gorge of a “pleasure now, pain later” approach.
Let’s face it – putting forward a plan to cut government spending or to increase taxes is a sure way for a politician to lose an election. Certainly, there’s not a peep coming from incumbent Congressional members or candidates running in the mid-term elections about US debt (or for that matter the rapidly depleting social security trust fund), from either side of the aisle. Rest assured though that at some point, the US government will need to clean up its mess, too. And as we are seeing now with the UK and with France, this is very unlikely to occur until the US government – meaning the president and Congress – have their backs against the wall and are forced to make difficult decisions.
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