Traditionally, bond markets are dull affairs, though not lately. In April, a fascinating thing happened: stocks markets tanked and bonds also fell. Traditionally bonds have offered a haven in plummeting equity markets - though not this time. Soon after, Moody’s downgraded the US’ sovereign credit rating.
This has caused some introspection among investors who are grappling with questions such as:
What’s behind these bond market ructions?
Why is government debt back on investor radars?
Why now?
Will bond market wobbles continue?
Is US debt really at risk?
Could bond market woes eventually impact stock markets?
The backstory
To get answers, it’s important to understand the context to recent events.
Government debt around the world has skyrocketed since the Global Financial Crisis. In 2008-2009, governments took on huge amounts of private debt to help save the financial system. A deflationary bust post that made it difficult for countries to grow their way out of this debt. And public debt levels had another leg-up during Covid as lockdowns and healthcare required huge additional spending.
With many major countries running large budget deficits, the IMF expects government debt to climb further in the years ahead, to about 100% of global GDP.
It’s not hard to see why the IMF believes budget deficits and government debts will continue to rise. Healthcare and social spending have ramped up significantly in recent years and as populations age across most major economies, it’s difficult to see this slowing down. It will not only pressure spending but also drain tax bases too.
Global defence spending is also expected to significantly increase to fund Ukraine’s resistance against Russia and plug the gap from America’s withdrawal from geopolitical hotspots. Lately, Europe has spent less than 2% of GDP on defence but the IMF and others think this could soon rise to 4-5%.
In an article last week, I outlined how Australian government spending jumped 9% last financial year, and that growth was unlikely to abate given the increasing health care and pension needs of our ageing population, the ever-expanding NDIS program, and forecast rises in defence expenditure from relatively low levels. That’s expected to result in growing budget deficits over the next decade.
Why are bond markets just waking up to sovereign debt risks?
Why are bond markets reacting now? After all, government debt in many major countries has been high for some time.
It can be put down to a combination of the following factors:
- The return to more normalized interest rates has pushed up interest costs on government debt and further increased budget deficits in the likes of the US.
- Trump’s tariff policies have fuelled concerns about the potential for inflation to reverse course and move higher again.
- Trump’s proposed tax and spending bill has added to market concerns about the large US budget deficit.
- US influence over the global economy means that rising Treasury yields are leading to higher yields elsewhere.
Markets haven’t been worried about government debt until now because this factor alone isn’t a precursor to a sovereign debt crisis. It was a good indicator for Sri Lanka’s crisis in 2022, when debt exceeded 100% of GDP. Yet, Argentina collapsed in 2001 with much small debt ratios of below 50% of GDP.
Schroders believes that other factors such as debt servicing costs and reliance on foreign funding are better predictors of credit risk. Because of that, it says markets are right to be concerned about higher interest rates and the strains that will put on government balance sheets.
The debt risk scorecard
What’s the best way to assess government debt risk? Schroders has come up with a framework of four key components with 12 indicators.
The four components are:
- Macroeconomic - whether debt as a share of GDP is growing or shrinking.
- Debt dynamic – three indicators assessing current debt position, interest burden, and forecast spending for next financial year.
- External vulnerability/liquidity – three indicators to determine each economy’s vulnerability to the external environment.
- Political and demographic risks – capturing non-quantitative risks such as months to the next election to incorporate the potential for populist policy change as well as the old-age dependency ratio as an indicator of future budget pressure risk.
Here is Schroder’s final scorecard for the G20 countries. Each country is ranked from one to 19 (there are 19 countries in the G20 – go figure) in each category, and that adds up to a final score and overall rank.
Source: Schroders
The first thing to note is that of the top four countries with the worst score, four are developed markets – the US, France, Italy, and Australia. Of emerging markets, only Brazil makes the list. Developed markets may be the new emerging markets, it seems.
Why is the US deemed the biggest sovereign debt risk? Schroders says it’s primarily because of large, twin current account and budget deficits that mean the US is reliant on foreign capital inflows to sustain its debt pile. The firm notes America’s score would have been worse if not for solid nominal economic growth. And the relative strength in political and social factors for the US may be misleading given the newly elected Trump administration has created huge policy uncertainty, while its anti-immigration policies are likely to worsen the old-age dependency ratio over time.
There are caveats to this negative view, though:
“… the US has historically been a special case. It benefits from having the world’s reserve currency, a vast store of assets, and the most dynamic financial markets. There is speculation that the erratic nature of US policymaking has dampened the appetite of foreign investors to buy US assets. But so long as it lasts, this “exorbitant privilege” will continue to allow the US to sustain deficits and debt levels that would trigger crises in other countries.”
It shouldn’t come as a shock that France and Italy feature high up on the scorecard.
However, Australia ranking fifth is a surprise, at least to me. Looking at the chart, we’re in decent shape for the macro and debt dynamic categories. It’s the external vulnerability and political risk factors that let us down.
We rank the second worst when it comes to our current account balance and net international investment position. High foreign investment in primary sectors like mining is a key aspect here.
Australia is also let down by its short election cycles, which result in poor ratings for political risks.
Of other countries, Japan’s 13th ranking may seem counterintuitive given its notoriously huge gross government debt to GDP ratio of 251%. That debt isn’t seen as a large risk because of a high domestic savings rate and domestic ownership of the bond market. Also, Japan’s interest costs as a percentage of GDP are also low, making it less vulnerable to higher bond yields. Finally, Schroders thinks Japan’s external risks are low given its current account surplus and the country having the highest net international investment position in the G20.
For those interested, here is the data that Schroders used for its sovereign debt risk rankings.
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Debates about improving productivity are heating up as the Labor Government waits for the results of five separate inquiries on the issue. In my article this week, I suggest that franking credits should be part of the debate into reforming our languishing economy.
James Gruber
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Curated by James Gruber and Leisa Bell
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