Bond markets are grappling with a growing pile of government debt

Published on27 SEP 2023

Government debt of the world’s developed economies has soared since the financial crisis and continues to grow. As central banks drive up interest rates to contend with a spike in inflation, those debt burdens are an increasing source of concern that could ripple through the bond market, according to Goldman Sachs Research.

The average ratio of developed market debt to GDP has risen to around 100%, up substantially from less than 70% before the financial crisis in 2008, says Goldman Sachs Research Head of European Rates Strategy George Cole. “This is a really broad-based phenomenon,” he says of the rise in borrowing. “Where you look at most of the developed market economies, you are really seeing very significant upward movement.”

Even as the amount of government borrowing piles up, the bond market for the most part “has taken a relatively sanguine view,” Cole says. The factors that tend to influence debt levels — inflation, economic growth, and spending deficits — suggest debt-to-GDP is going to rise, on average, further in developed markets. As borrowing climbs, he says there’s a risk that longer-term interest rates could end up higher than investors are expecting. “Although we might see a period of calm in bond markets, we do think the risks are skewed toward a higher risk premium as the market thinks about these risks,” Cole says.

He points out that his team’s research doesn’t focus on what exactly the so-called correct amount of debt is for a government, which is a contested debate. Instead, Goldman Sachs Research examined the factors that tend to lead to a significant change in debt-to-GDP, which could offer insight into where these debt levels are headed.

Inflation is a key determinant of government debt ratios

Goldman Sachs Research examined periods where government debt-to-GDP increased or fell by more than 10 percentage points over a period of years. On average, that kind of debt reduction tends to happen when the interest rate paid on the debt is a little below average; the primary balance (net government borrowing, minus interest costs) is a little stronger than usual; nominal economic growth is higher; and inflation is elevated. “You see the mirror image for debt increases,” Coles says: Interest costs are higher, primary balances are weaker (or deficits bigger), and growth and inflation are lower.

The 1980s were a key turning point for these dynamics. That’s when central bank policymakers began “inflation targeting” following the burst of inflation in the previous decade. That policy aim — controlling inflation as an anchor for the economy — was gradually formalized in most developed markets, targeting a rate of around 2%. “That period, from 1980 on, was a journey of inflation moving much, much lower — from very high levels to a much lower equilibrium,” Cole says. “What that means is that inflation no longer becomes a channel through which it's very easy to affect your debt burden.”

The upshot is that the primary balance — the difference between revenue a government collects and spends, not including interest expense — now plays a much larger role when it comes to changes in debt. “That's because we don't have these huge swings in inflation anymore,” Cole says, noting out that economic growth is also a critical factor. “And it really does mean that it's the primary balance that is responsible for those shifts in debt.”

A way to analyze where a government’s debt-to-GDP is headed is to subtract its real (inflation adjusted) interest rate ( r ) from its real growth rate ( g ) — an equation symbolized by r - g. If the result is negative, the debt ratio is likely to fall (or could support a modest budget deficit). If that equation is positive, debt ratios are set to climb. On average, that number is moving into positive territory for developed economies, Cole says, suggesting debt ratios will climb.

Government debt ratios are poised to rise

If fiscal policy, rather than inflation, is the key determinant for government debt-to-GDP in the coming years, what does that suggest about the future of sovereign borrowing? Coles says it’s a mixed picture. But in most major economies, most notably the US, there aren’t plans to tighten budgets. “It does look like with current fiscal plans there is going to be a steady increase in the ratio of debt to GDP in the US,” Cole says. “If interest rates do not fall again, you will further compound that increasing cost to the economy via interest rates.”

On paper, Europe’s fiscal policy looks more disciplined. Cole says most countries there are projecting a primary surplus in the future, but much will depend on economic growth, whether energy costs are contained, and whether electorates will tolerate tighter budgets. “So our sense is that although they are moving in the right direction, they are still not yet aggressive enough to significantly lower the debt burden,” he says. “And again, we reserve judgment. Maybe they shouldn't given their current dynamics. We just suggest that there is not a lot of fiscal risk priced for an outlook that suggests no government is particularly keen or aggressive in reducing debt burdens.”

Of course, a build up in government debt doesn’t always cause the bond market to panic. Japan’s government debt-to-GDP ratio is more than 200% — around double that of the US. But Cole points out there are factors in Japan that help create equilibrium in the bond market, and those factors aren’t there in most places (such as a current account surplus, low levels of private debt, low levels of inflation and growth, and high demand for bonds).

Rising debt may push interest rates higher

Some of those Japan-like ingredients were there in big Western economies after the financial crisis. Interest rates in the US and Europe were low or even negative, while economic growth was anemic. “What we discovered was this was an economy that certainly was not worried about fiscal risks,” Cole says. “We lived in that world with very low interest rates and, if you like, excess demand for bonds for a very long period.”

But that’s not likely to be the case going forward. “If we find that inflation reasserts itself, as it has done over the last two years, the outlook for fixed income is very different,” Cole says. “You will ask for higher returns from these fixed income instruments because we know the way to wipe out returns from fixed income, particularly when low rates are still prevailing in the market, is you have high inflation.”

“If you add to that central banks no longer running this easy policy, we find that there are now consequences for running high debt-to-GDP ratios, which is that your interest costs will increase, and if your growth rates and inflation rates don't keep pace over time, then there is a question mark about who will buy these bonds,” he also says. 

Cole notes there’s already a recent example of the bond market gyrating because of a government’s plans to ramp up borrowing. UK gilt yields jumped late last year after the British government announced a budget that would have driven bond issuance higher (the jump in yields came down after the government reversed some of its fiscal plans). Coles says there were special idiosyncrasies at play in the UK market, such as the way the pension sector is constructed, but ultimately investor alarm was fuelled by fiscal concerns, inflation, and the amount of bond supply that appeared headed for the market.

“The point I would make is that this is not science fiction,” Cole says. “Already this cycle we've had an example of how these market pressures can manifest a huge increase in long-dated interest rates.”

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