The sharp decline in global government debt has exposed investors’ fears that the macroeconomic backdrop is shifting towards a sustained rise in inflation, as governments struggle to rein in spending and sovereign debt.
Pressure on yields is not just due to higher government borrowing and higher energy prices this year. Investors are highlighting the shift from globalization to protectionism and geopolitical tensions manifested in trade tariffs, deindustrialization, and increased defense spending as signs of broader changes that could keep inflation structurally high.
That would be a decisive break from the generally low and relatively stable inflation environment that followed the global financial crisis, and would have far-reaching implications for investor portfolios.
US 10 year government bond.
“The structural features of the global economy have changed and are now creating an inflationary impulse rather than a disinflationary one,” said Emma Moriarty, portfolio manager at CG Asset Management.
“Tariffs, and more recently the outbreak of war in the Middle East, marked an abrupt end to this changing order. It would be a mistake to think of energy shocks as temporary, because the fundamental structural changes that caused them may be quite long-lasting.”
Public debt is “soaring” and “coming home to roost”
US 10 year treasury This week, yields rose to their highest level since November 2023. Japanese 10 year government bond Yields exceeded 3% for the first time since 1996. In the UK, yields have exceeded 3%. 10 years gilts German government debt, a measure of British government debt, hit its highest level since 2008. 10 year bond Yields, a barometer of eurozone borrowing, rose to levels not seen since 2011.
Long-term yields in these countries have also reached their highest levels in years or decades.
John Cunliffe, head of investment at JM Fin, said that while cyclical inflation pressures may continue to ease, investors should not assume a return to the persistently low and stable inflation regime that prevailed from 2010 to 2020.
“The key unknown is how much disinflationary traction AI will exert through significant productivity gains. This is certainly what new Fed Chairman Kevin Warsh is counting on as U.S. policymakers grapple with expanding fiscal control,” Cunliffe told CNBC via email.
Japan 10 year bond.
Investors say this week’s rise in yields, particularly on long-term rates, highlights investors’ demand for higher term premiums in the face of growing fiscal borrowing demand, persistent inflation uncertainty and reduced central bank support for government debt in some major countries.
Callanish Capital CEO Haig Bathgate said in an interview with CNBC on Wednesday that while this week’s decline reflects some short-term noise, sustained inflation across the term structure “is going to be a feature of the market going forward.”
Mr Bathgate said of the “spiral” in public spending: “At some point this will come home to roost.”
“If we look back at the history of the ’70s, we know that once the inflation genie is out of the bottle, it’s very difficult to get it back in,” he added. “It’s lasted a lot longer than anyone thought.”
Central bank headaches
Central banks now face increasingly complex challenges over the trajectory of interest rates, as inflation remains susceptible to supply-side shocks and geopolitical turmoil, but policymakers are wary of aggressive tightening amid slowing growth.
“In this context, the Bank of England and the Federal Reserve could allow for a temporary inflation overshoot while monitoring whether the effects of the second phase of wage and price setting emerge,” Cunliffe said. “Elsewhere, however, the ECB and the Bank of Japan have taken a clearer path to tightening, with the former targeting inflation rather than growth, and the latter normalizing monetary policy as both growth and inflation are on sustainable footing.”
Following Federal Reserve Chairman Kevin Warsh’s keynote speech in Jackson Hole, Wyoming on Friday, Aug. 28, the probability that interest rates will be raised at the next Federal Open Market Committee meeting later this month rose to more than 66%, up from about 35% before his remarks.
10-year German federal bond.
Padraic Garvey, head of Americas research and global interest rate and debt strategy at ING, said the Iran war and rising energy costs are putting further upward pressure on long-term interest rates. “This is a real issue that countries in particular in Europe, Asia and indeed beyond need to address,” Garvey said in a memo Thursday.
brent crude oil Crude oil, the international oil price benchmark, rose more than 1% on Thursday to a one-month high of $96.64, but in the U.S. west texas intermediate Prices rose 1.6% to trade at $92.52 per barrel.
“If the music were to stop now, the absolute level of long-term rates for many issuers would look reasonably fair. The problem is, the music is still playing. There’s a lot going on, and most of the pressure continues to be directed upwards at long-term rates. It doesn’t have to be a drama, but it could be if it goes too far,” Garvey added.
“It’s hard to see the pressure for higher long-term interest rates magically disappearing.”
Garvey said the market price for a 25 basis point (bp) rate hike at the Federal Open Market Committee meeting in September has gone from about 50-50 to 3-1 in favor.
UK 10 Year Gilt.
The jump in yields is also reshaping portfolio trade-offs for investors.
“Increasing inflation volatility tends to increase the correlation between stock and bond markets, reducing the diversification benefit of holding the latter in a balanced portfolio,” said John Stopford, head of multi-asset and income at NinetyOne. “However, rising real interest rates will raise the cost of capital, potentially making fixed income a more competitive asset class, especially as equity valuations are likely to rise.”
Brian Mangwiro, managing director of Barings’ global fixed income team, said government bond funds should be defensive with shorter duration products.
“Multi-strategy fixed income funds can also focus on high returns, but are again biased towards shorter durations. In the case of the US, the decline in US Treasuries and ongoing curve steepening also coincides with a weaker US dollar. This is generally bullish for emerging markets.”
