Investors could be underestimating the risk of new sovereign debt blow-ups in advanced economies, including the US, as rich countries’ debts expand and spending becomes looser, a top International Monetary Fund official has told GlobalMarkets.
Tobias Adrian, financial counsellor and director of the IMF’s monetary and capital markets department, warned there could be other moments akin to the UK’s Gilts crisis that accompanied Liz Truss’s short-lived premiership in September-October 2022.
After a fiscally expansive Budget, government bond yields spiked, forcing the Bank of England to intervene, reversal of the unfunded tax cuts, and then the fall of the government.
“When governments shift fiscal policy suddenly, in meaningful manners, that does have an impact on [bond] pricing and can lead to sharp readjustments or sell-offs, which can trigger financial stability concerns,” Adrian said. “Governments have room to adjust revenues and spending, but can there be bouts of volatility? Yes, absolutely.”
Since France called a snap election in June, the 10 year French government bond spread over German Bunds has widened from 50bp to 74bp.
Both the left wing and far right blocks, which performed strongly in the election, want to roll back pension reform and increase the budget deficit.
Adrian pointed to a recent deterioration of liquidity in the US Treasury market. He said it reflected higher interest rate volatility, as central banks have moved away from forward guidance to data-dependent monetary policy. This was “fairly contained in aggregate”, he noted.
Nevertheless, he pointed to data from the US Congressional Budget Office this summer, warning that US national debt held by the public would surpass 100% of GDP next year and continue to increase into the 2030s. Both candidates in the US presidential election next month oppose reductions in social security and healthcare entitlements.
Among poorer countries, the IMF sees encouraging signs. Adrian said some low income countries that were shut out of bond markets in 2023 had since regained access. And despite pressure in some weaker emerging economies, he said middle income countries generally were resilient, thanks to what he called policy improvements.
“There’s more monetary policy credibility, and on the fiscal side, we do see risks as contained, in the major emerging markets,” Adrian said.
But in advanced economies, debt-to-GDP ratios had risen by 15 percentage points on average during Covid-19, said Adrian — and except for countries such as Germany, they have kept going up.
“When you look at other G7 economies you do see continued expansionary deficits, particularly in the US,” he said.
Research from S&P Global Ratings in July suggested France, Italy and the US’s debt-to-GDP ratios would all rise further over the next three years.
Even within the developed world, the hierarchy is changing. Some peripheral eurozone countries, previously plagued by sovereign debt worries — such as Greece and Portugal — have been profiting from a tourism boom to reduce public debt. Greece’s 10 year debt now trades just 16bp wider than France’s and Portugal’s 17bp tighter than it.
Quantitative tightening, as central banks unwind years of stimulus, is adding to the upward pressure on G7 countries’ longer term funding costs, just as government debt issuance is rising because of higher fiscal deficits.
That has pushed interest charges up as a percentage of GDP, making it harder for governments to afford the costs of ageing populations, higher military spending and climate change.
In spite of these strains, risk premia across financial markets are tight by historical standards, relative to base interest rates, according to the IMF. Adrian says this is despite a high degree of global government policy uncertainty, including around elections. “While this geopolitical uncertainty is fairly high,” he said, “there’s a disconnect that could trigger a readjustment of financial conditions at some point.”