Bond trouble

Bond trouble

Borrowing is becoming more expensive for western governments. Last Friday the interest rate, or yield, on US 30-year government bonds reached 4.96%, the highest level in 16 years. German bond yields at close to 3.0% are back to levels last seen during the euro crisis in 2011. UK 10-year bond yields are higher now than they were at the height of the sell-off in the wake of the mini-budget a year ago.

• Rising borrowing costs partly reflect rising central bank interest rates and a conviction that they are likely to stay at elevated levels for some time. The yield on a bond also offers compensation for the risk of unexpected shocks, such as surging government borrowing or higher inflation. Recent strong data from the US, including Friday’s jobs numbers, have added to concerns about inflation. At the same time, governments are continuing to borrow on a significant scale.

• High levels of borrowing might be thought to drive interest rates higher. But in recent decades inflation and central bank interest rates have tended to dominate. Yields on government bonds trended lower from the early 1980s to 2022 despite rising government borrowing. Yields dipped to an all-time low in the pandemic at a time of surging government borrowing and spending. By and large the supply of government debt has not been a major driver of bond yields.

• The dynamics are arguably different now. Inflation is no longer quiescent, as it was during the period of ever-falling bond yields. And central banks, rather than buying government bonds in an effort to drive down yields, as they did from 2008, are selling them.

• Public sector debt levels have ballooned in the last 15 years. In the US the ratio of public sector debt to GDP has more than doubled in the last ten years and is higher now than at any time since the early 1940s. Put another way, countering the financial crisis and the pandemic has had a greater effect on US debt levels than fighting the second world war.

• Public borrowing has continued to grow even though the shocks that drove sharp increases in public indebtedness – the 2008 financial crisis, the pandemic in 2020 and last year’s energy crunch – have passed.

• Up until now the effects of rising government indebtedness on interest payments have been more than offset by declining levels of market interest rates. In 2021, for instance, UK government interest payments as a share of GDP fell to the lowest level on record even as debt reached a 60-year peak.  Governments haven’t had to worry too much about rising public debt levels in a world of low interest rates.

• That is changing, especially since it is hard to see much public or political appetite for debt reduction. The ousting of House speaker Kevin McCarthy in the US does not bode well for the sort of bipartisanship that would be needed to address the rise in US indebtedness. The latest British Social Attitudes Survey shows that public support for an expanded role for government has reached an all-time high. UK voters show little enthusiasm for a smaller state, with 55% of respondents saying that taxes and public spending need to rise still higher.

• Barring an abrupt change of course, public sector debt levels seem likely to keep rising. In the US, where we have long-term official forecasts, the projections are eye watering. The US Congressional Budget Office estimates that health and welfare costs will outpace US GDP growth, taking public debt from 98% of GDP today to almost 200% in 2053.

• There are three obvious implications from all of this.

• The first is that the public – and governments – will have to get used to paying more to service existing debts. In the case of the UK, that means spending around 3% of GDP each year on servicing public debt, three times the level two years ago. Debt interest is now a major item of government expenditure and an unavoidable call on public resources. Debt-financed public spending is less attractive and riskier now than when the UK government could borrow for ten years for almost nothing, as was the case in 2020.

• From this a second point follows. Governments face greater scrutiny of their spending and borrowing plans from bond markets.  A fortnight ago, the Italian government raised the forecast for its deficit this year from 4.5% to 5.3% of GDP, unnerving bond markets and pushing up the premium over Germany required by investors to lend to Italy. Markets worry that with public debt equivalent to almost 150% of GDP, and a trend growth rate of under 1.0%, Italy could struggle to service its debts. Pressure from financial markets, in the form of higher rates, is likely to act as an increasing constraint on public spending. (In Italy’s case, the European Commission and the European Central Bank are also likely to press for fiscal consolidation and for measures to boost growth.)

• The third implication comes from levels of bond yields. These show that financial markets foresee no return to the low interest rates that were the norm until 2021. On the contrary, market pricing implies that rates will stay at high levels for years to come. Those expectations may prove wrong, but that is what the bond market is saying. Corporates and households need to adjust to a world of higher rates.  

• Markets will doubtless buy this debt, the question is at what price (and, since the yield is a function of the price, at what yield).

For the latest charts and data on health and economics, visit our Economics Monitor:
https://www2.deloitte.com/uk/en/pages/finance/articles/covid-19-economics-monitor.html

OUR REVIEW OF LAST WEEK’S NEWS
The UK FTSE 100 equity index closed the week down 1.5% at 7,495. UK and global equities fell last week as markets expect interest rates to remain higher for longer.

Economics

• UK prime minister Rishi Sunak confirmed that the northern leg of HS2 will be scrapped and replaced with funding for local transport projects in the North of England
• UK prime minister Rishi Sunak announced that he is replacing A-levels and T-levels with a new Advanced British Standard where pupils will be required to study five subjects including some form of English and Math
• UK chancellor Jeremy Hunt ruled out imminent tax cuts until public sector spending has been reigned in as he announced a $1bn plan to reduce civil service personnel
• UK construction activity fell more than initially registered in September while services only contracted marginally, according to the final readings of the S&P Global/CIPS UK construction purchasing managers’ index
• UK house prices fell 0.4% in September, making it six straight months of falling house prices, according to Halifax
• US jobs openings unexpectedly rebounded in August and job growth was stronger than expected in September adding pressure on the US Federal Reserve to keep interest rates higher for longer
• US treasury 10-year yields hit a 16-year high, reaching 4.8% for the first time since October 2007 as rates are expected to stay high for an extended period
• US manufacturing contracted in September for the 11th straight month due to slowing demand, but employment rebounded as companies reduced their workforce mainly through attrition and hiring freezes rather than redundancies
• US junk corporate bonds rose to 9.33% as the premium paid by riskier companies widened due to higher long-term interest rate expectations
• Euro area monthly retail sales in August fell by 1.2%, the fastest pace this year as inflation and borrowing costs squeeze demand
• European house prices grew by 0.3% in Q2 2023 after falling in the previous two quarters despite high mortgage rates and weak economic growth
• Brent crude oil price fell to $84 per barrel on Friday as markets worry that a sustained period of high interest rates may dent demand
• Manufacturing sentiment in Japan rose in Q3 2023 driven by a “solid industrial production growth” despite a challenging global outlook
• Ukraine’s central bank de-pegged the hryvnia from the US dollar in favour of a “regime of managed flexibility” for the first time since Russia’s invasion
• The RMT union called off the strikes after “significant progress” with London Underground management that averted job cuts

Business

• Tesla reported a 7% fall in vehicle deliveries in its second quarter of 2023 due to factory shutdowns and slowing demand for electric cars
• General Motors and Ford announced an increase in annual vehicle sales in Q3 2023 as the impact of union strikes in September is yet to be felt
• Spotify reached a deal with publishers to offer subscribers free audiobooks in a bid to compete with Amazon’s Audible service
• Widespread adoption of weight-loss ‘GLP-1’ drugs such as Ozempic over the next three years could lead to a thinner population and weaken demand for hospital procedures and fast food, according to Barclays
• Struggling Scandinavian airline SAS reached a rescue deal with Air France-KLM, private equity firm Castlelake and the Danish state, which effectively wiped out its shareholders
• Carlsberg wrote off the value of its Russian business Baltika following the Russian state’s “illegitimate takeover” of the business
• From 2025, UK insurers will face a ‘dynamic’ stress test that will simulate “a sequential set of adverse events over a short period of time”

• *Metro Bank is seeking an urgent capital injection of £600m to shore up its balance sheet, according to the FT
• US retail spending during the holiday season is set to be boosted by record levels of sale discounts and use of buy now pay later platforms, according to Adobe

Global and political developments

• Israel declared itself at war following a deadly Hamas assault in southern Israel, which has resulted in at least 1,000 confirmed casualties so far
• The United Nations Security Council authorised a security mission to fight gangs in Haiti who control parts of cities in the aftermath of president Jovenel Moise’s assassination
• IMF managing director Kristalina Georgieva said she supports reforms to give China more voting powers to ensure the Fund has adequate aid resources
• The World Health Organisation recommended the deployment of a $4 malaria vaccine made by Oxford University
• US president Joe Biden reassured Ukraine that it could count on the support of the “vast majority of both parties” after Congress dropped plans for $6bn in aid to avoid a government shutdown
• US Republican Kevin McCarthy was removed as speaker of the House of Representatives as 208 Democrats and 8 Republicans supported the “motion to vacate”
• The Scottish Labour Party won the Rutherglen and Hamilton West by-election, unseating the Scottish National Party incumbent

And finally… Metro reported last week that a man with a pet turkey goes everywhere with her - even to the dentist. The man said he adopted the turkey, named T2, after she was abandoned by her mother. He said T2 is very intelligent and affectionate, and that they have a special bond. Fortunately, he also confirmed that he has no plans to eat her for Thanksgiving - that would be a fowl play