Bond Market Rally Overlooks Soaring $2 Trillion Debt Crisis

At the onset of November, the bond market witnessed a conspicuous absence of two words: "debt supply." The surge in bond prices worldwide, leading to declining yields and favorable returns for investors, temporarily dispelled concerns about escalating budget deficits. However, the question arises – how long will this reprieve last?

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In the coming weeks, the US, UK, eurozone, and Japan are poised to inundate the market with bonds, reaching an unprecedented pace. These nations, grappling with inflated deficits once deemed unthinkable, are expected to issue a net $2.1 trillion in new bonds to fund their 2024 spending plans, marking a 7% increase from the previous year, according to Bloomberg Intelligence estimates.

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With central banks no longer absorbing bonds to stimulate economic growth, governments now face the challenge of attracting buy orders from global investors. The prevailing thought is that to achieve this, they may need to offer higher yields, reminiscent of the strategy employed when concerns about escalating government debt prompted Fitch Ratings to strip the US of its AAA credit rating last summer. This event triggered a market rout, propelling the rate on benchmark 10-year Treasuries above 5% for the first time in 16 years.

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Although recent anxieties have subsided, largely due to slowing inflation and the anticipation of central banks cutting interest rates, many bond-market analysts contend that, given the current supply-and-demand dynamics, it's only a matter of time before concerns about the deficit resurface. Bond yields have already surged higher this year, with the 10-year rate now hovering around 4%.

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"The market is just obsessed with the Fed rate cycle right now," observes Padhraic Garvey, head of global debt and rates strategy at ING Financial Markets. "Once the novelty of that fades away, we'll start to worry more about the deficit."

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Public debt across advanced economies has surged to over 112% of GDP from about 75% two decades ago. Governments increased borrowing to fund pandemic stimulus programs, healthcare, pensions for aging populations, and the transition away from fossil fuels. The Bank of England and Harvard University researchers estimate that each percentage-point increase in a country's debt-to-GDP ratio raises market rates by 0.35 percentage point.

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Despite these calculations, the correlation between soaring debt loads and rising borrowing costs has not played out as expected in recent years. Treasury yields have declined as the US debt-to-GDP ratio escalated. However, Garvey suggests that, with the US running annual deficits double the historical norm at 6% of GDP, an additional percentage point may be added to yields, potentially creating a detrimental cycle of increased government interest payments and deepening deficits.

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While public finances in other countries may not be as dire, the UK, Italy, and France are expected to post larger-than-normal deficits this year. Elections in various nations will keep these shortfalls in the spotlight, with warnings that increased government spending pledges could trigger bond sell-offs.

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Steven Major, head of global fixed-income research at HSBC Holdings, challenges the conventional concern over debt supply, using an analogy about farmers selling potatoes. He argues that an increase in supply doesn't necessarily lead to a drop in price, as the demand side remains unknown. Moreover, in times of recession, demand for the safety of government debt tends to rise.

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Major contends that governments can adjust their debt offerings based on demand, scaling back sales of longer-term securities and offering more shorter-term debt if needed. The US employed this strategy in the past, adjusting the mix of bond sales to stabilize the market during turbulent times.

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Despite reassurances from certain quarters, concerns persist about the impact of soaring debt loads on borrowing costs and economic growth. Alex Brazier, deputy head of BlackRock's research arm, identifies slowing global growth and higher benchmark interest rates as key challenges. Central banks, including the European Central Bank, Bank of England, and the Federal Reserve, have raised rates to combat inflation triggered by pandemic stimulus programs. Even if rate hikes are reversed, the return to the zero-rates era seems unlikely.

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Brazier emphasizes that with higher benchmark interest rates, the ability to grow out of debt diminishes, leading to a larger interest bill. Countries like France and Australia are grappling with mounting interest payments, threatening to exceed defense budgets and double within a few years. The World Bank predicts a decline in potential global growth to its lowest level in three decades, exacerbating concerns about fiscal deficits.

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In conclusion, the dilemma surrounding the interplay of debt supply, borrowing costs, and economic growth remains complex. While some argue that increased supply doesn't necessarily lead to lower bond prices, others caution that it could influence demand dynamics. As governments gear up to issue a substantial amount of new bonds, the market's response will likely determine the trajectory of yields and the broader economic landscape. Investors are advised to navigate cautiously, with some experts recommending steering clear of long-term bonds amid the prevailing uncertainties.