The elephant in the room

Since the end of the austerity policies that followed the GFC (Global Financial Crisis), debt growth has been concentrated in governments. This has further accelerated since COVID.

The full impact of this has been somewhat obscured by the bond purchasing programmes deployed by central banks across the world, following in Japan’s footsteps.

After the spike in inflation that set in in 2022 lead to a sell-off in bonds, global monetary policies have become much more restrictive and rising rates have been accompanied by the end of bond-buying by monetary authorities – or even by them selling their holdings.

Typically, high-grade government debt like US treasuries, British gilts and German bunds are seen by investors as the ultimate ‘risk-free’ assets and liquidity havens – this is also linked to the derivatives market, including interest rate swaps.

However, the events in the UK gilt market in October 2022 rocked that perception. Not only did gilt prices fall at an unprecedented speed, but liquidity also became strained. There are increasingly signs that the glut of government bonds is changing the dynamics that investors have become used to in recent decades.

Yields versus swaps

When looking at current government bond yields in some major markets, we can make some interesting observations. At the time of writing, yields on gilts and US treasuries are higher than swap rates. In the longer-maturity spectrum, bunds are trading at a 0.4% higher yield than swaps, and the yield on 30-year gilts is more than 0.75% higher than the comparable swap rate[1]. While it is not that uncommon historically for government bonds to trade above swaps, the current levels are exceptional in our view.

This difference between government bond yields and swap rates (also called the swap spread) is a function of multiple factors. 

The relative supply of government bonds (or relative scarcity) is key. In its latest Fiscal Monitor, the IMF calculated that global public debt would rise above $100 trillion by the end of 2024 and reach 100% of world GDP by the end of this decade[2]. This supply is linked to fiscal deficits, which in turn has implications for the credit ratings of government bonds. 

These ratings may be another factor in why we see these differences between the major markets, with US treasuries and gilts on downward trajectories and now in the AA category, while German government bonds still enjoy the highest rating. In addition to the longer-term secular increase in bond supply, leverage as measured by public debt-to-GDP ratios showed a clear spike during COVID as governments subsidised both companies and individuals[3].

The charts clearly indicate that after a short drop following the COVID spike, the ratios continued on a strong upward trajectory in both the US and UK. Looking at the US, there was no sign that either party would engage in any meaningful debt reduction, but the Trump agenda combined with the Republican sweep in the recent American election is expected to further drive up the deficit.

In the UK, the latest budget left the door open for higher borrowing, with increased leeway for investments. The sideways move for the EU masks a strong divergence within the block, with a move downward in Germany mitigating the strong rise in French debt and high levels for Italy. However, the current debate in Germany about releasing the ‘debt brake’ might change this, with Europe more broadly joining the spending spree.

Trillions and trillions

With credit ratings for US treasuries now well below their highest levels and on a downward trajectory, there is an estimated increase in the American national debt of $1 trillion USD every 100 days[4]. Combined with the future burden of an ageing population, this increasingly raises questions about the valuation of American government bonds versus highly rated corporate bonds. 

In the investment grade USD corporate bond market, spreads versus treasuries are at historic lows (in their first percentile) and other markets appear to be moving in the same direction[5]. 

While the elephants are dancing for now, the music may one day stop, and governments could face funding pressures they have not witnessed for many decades. In such a scenario, we should all brace ourselves, as government debt will still anchor the whole fixed income universe. 

[1] Source: Bloomberg as at 15 November 2024
[2] IMF Fiscal Monitor October 2024
[3] IMF World Economic Outlook database, October 2024
[4] https://www.cnbc.com/2024/03/01/the-us-national-debt-is-rising-by-1-trillion-about-every-100-days.html
[5] Source: Bloomberg as at 15 November 2024