Will the Bond Bomb Explode?

Japan Is Managing for Now: The yield on its 10-year bonds has topped 3% for the first time since 1996, but inflation has also risen, and debt relative to the economy is shrinking.

According to Ambassador Arjan, bankers used to say that unlike companies, they do not go bankrupt. They repeated this encouraging slogan until in the 1980s a wave of Latin American countries failed to repay their loans. Will a shock similar to the wind empty the pride of rich countries?

Five years ago, borrowing was so cheap that government debt seemed almost free. Today, investors are selling bonds in droves, and many big, rich governments are borrowing more expensively than at any time since the 1990s or 2000s. Their debt compared to the gross domestic product (GDP) is about twice that of the beginning of the century. The result? Heavy pressure on budgets.

Even before the recent selloff, these governments were expected to spend 8% of their tax revenue on net debt interest this year, as aging populations and the risk of war push for more spending. Now the extension of debts has become more expensive and many people still borrow without accounting. Finally, one day the investors will revolt.

Ironically, part of this selling wave is good news. The American economy is booming and its growth may be more than 3% annually. AI companies are scrambling to build data centers and competing with governments for capital. The result is a higher interest rate.

This has intensified the more unpleasant pressures. The energy shock caused by the war in Iran has increased inflation and in the age of populism, the credibility of economic institutions is gradually being doubted. 🔥 Trump recently said that inflation can reduce the debt "very quickly" and again criticized the Federal Reserve for not reducing interest rates. Bond investors see risk: Governments may hit their pockets with inflation.

America is realizing that the boom in artificial intelligence will not help much with its debt, because interest costs will rise along with growth. Its annual budget deficit, around 6% of GDP, is not sustainable. But Uncle Sam has a trump card: the dollar, the world's reserve currency, which has soared in recent weeks. The day of reckoning is coming, but not soon.

Japan has also recovered for now. The yield on its 10-year bond exceeded 3% for the first time since 1996, but inflation is rising and debt to the economy is shrinking.

Europe is where the crisis is closest. The boom in artificial intelligence has increased the cost of capital there, but it has not received much growth, and expensive fuel is putting pressure on its energy-importing economy. Germany, Scandinavia and Switzerland have their budgets on track, but Britain, France and Italy are faltering.

Britain 2022 has already seen a bond market riot, but its debt-to-output ratio is still rising. Italy's net debt is relatively stable, but 129% of GDP is huge and could break in a panic.

France is under the most pressure: its budget deficit is forecast at 5.4% of GDP this year. According to the Economist, at current growth rates, if France were to roll over all its debt at current five-year bond yields, it would need to tighten its belt by more than 4% of GDP to stabilize debt. But the country is involved in student protests and its parliament barely approves a budget with one-tenth of this savings.

Investors recently forced France to pay 1.5 percentage points more than Germany for a ten-year loan; The longest distance since the eurozone debt crisis. Before the 2027 presidential election, Marine Le Pen, from the populist right, is leading the polls. Her Oct. 6 pledge to shrink the budget and cut the debt ratio in half pushed bond yields down slightly, but Le Pen herself has little credibility: she still promises to lower the retirement age, even as people live longer.

Escape from French bonds may happen. Then maybe the government will ask the European Central Bank to save it instead of austerity. The rule is that countries fix their budgets before the bank buys their debt, but this barrier is looser than it was a decade ago. In this game of "who comes first", a populist president is likely to win; Because the European Union does not survive without France.

It is a mistake to bail out governments that do not completely balance the budget. The central bank's job is to open the clogged pipes of the financial system, not to guarantee decades of reckless borrowing. If central banks become proxies for finance ministries, long-term bond selling will intensify and voters will retaliate.

The best way, in France and elsewhere, is for politicians to explain to the public that the government debt must be curbed and everyone to do whatever it takes.