Fixed income investors are often characterised by their patience and loyalty. However, lately, holders of sovereign debt have ample reasons to be concerned. It is becoming increasingly evident that the accumulation of public liabilities compromises their sustainability unless the current trend is reversed. The inability to curb imbalances in public finances paints a long-term picture that is anything but reassuring. There is neither the will nor sufficient political consensus to consolidate public accounts in the major Western economies.
France is a good example of this dangerous drift. It was enough for the government to propose raising the retirement age above the current 60 years to provoke a revolt in the streets. Attempts by the government to close the budget gap by applying minimal austerity have met with staunch opposition from both the left and the far-right, which together enjoy a significant majority in Parliament and in the polls. With a mismatch reaching nearly six percent of GDP, the absence of fiscal responsibility undermines confidence in both French debt and, by extension, in the future of the euro. Germany, for its part, has lost the aura of solidity of its bunds by embarking on an ambitious public spending plan for defence and infrastructure modernisation. Not to mention the United States, which is mired in increasing imbalance due to the weakness of federal revenue, unable to cover the vast allocation of mandatory spending on pensions and healthcare, not to mention the military.
Nevertheless, the margins on sovereigns still do not reflect their potential future risk, undoubtedly due to the blind faith placed in the belief that markets will continue to refinance sine die the mountain of liabilities issued by states. There are plenty of examples of such behaviour. Countries with a tradition of substantial indebtedness, such as Japan or Italy, have not experienced excessive difficulties in renewing maturities and accumulating additional burdens.
The palpable unease that has been raising sovereign yields lately comes, above all, from discounting the effect of the rampant inflation that is gripping the global economy.
The palpable unease that has lately been driving up sovereign yields comes primarily from discounting the effect of rampant inflation that is gripping the global economy. The problem now centres on the increasingly widespread appreciation that price levels are on a path to embark on an upward trajectory, with few prospects of abating. The conflict in the Middle East is dragging on without signs of a near conclusion, having a notable impact on the prices of energy products and derivatives. The forced contraction of supply has so far been mitigated, in large part, by lower demand and the massive use of reserves accumulated by the United States and China. A worse fate has befallen the supply of refined products. Unless this situation is alleviated, the bill will continue to be passed along the value chain of the entire sector, feeding a price spiral.
The risk of the global economy experiencing persistent inflation is, therefore, the main factor weighing on the flight of investors from fixed income. More intensely, if possible, the impact is felt in the debt issued by states as the spreads of corporate debt narrow. The huge investments required to fully operationalise artificial intelligence are translating into increasing issuances of securities by technology companies, further pressuring the market with their presence. In such a scenario, it is no surprise that sovereigns are experiencing significant upheaval. Their ten-year yields are approaching 5% in the United States and surpassing the 3% barrier in Germany and Japan. Markets are independently raising the cost of credit, placing central banks, which are increasingly slow to react, behind the yield curve.
Only the ECB has acted with undeniable promptness, marginally raising its rates in June and presumably operating an additional adjustment of similar magnitude this month. It started from a comfortable situation of low rates that provides room to undertake these calculated movements without affecting either activity or the debt market. The Federal Reserve, despite the reiterated commitment to stability expressed by Kevin Warsh, is still waiting. There are, without a doubt, valid reasons to distrust that a tightening of monetary policy would be the most effective remedy to curb cost-push inflation. Nevertheless, excessively delaying the reaction can only encourage an expansion of its impact. If central banks cannot counteract the rising costs of oil or natural gas with rate hikes, as Christine Lagarde pointed out in the past, they play an essential role in diluting inflationary expectations, above all preventing contagion from turning into a perverse spiral of prices and wages. This is a second-round phenomenon of greater scope and persistence than the initial shock.
They play an essential role in diluting inflationary expectations, primarily preventing contagion from becoming a perverse spiral of prices and wages
The underlying problem is that central banks have little room for manoeuvre in such an unpredictable scenario as the current one. No one dares to predict how long the struggle blocking the normal supply of crude oil may last. Even less so its ultimate impact on inflation. It is not surprising that monetary authorities have preferred to subscribe to the thesis of a reversible temporary mismatch of relatively short duration. An opinion that the markets do not share and which, day by day, seems less plausible, even to central bankers. However, they observe with relief that there are, at least for the moment, no signs of second-round effects. They are also aware that deploying their firepower is only fully effective in addressing overheating of the economy caused by demand-side imbalances. Using ammunition against supply crises is akin to wasting ammunition with the added risk of destabilising the debt market, which is critically important for the stability of the financial system. Ultimately, central banks are increasingly becoming prisoners of their role as a last resort to secure sovereign issuances. Contributing to the monetisation of the public deficit amounts to a reduction of their independence that they have long accepted and factored in. As long as governments do not take seriously the need to put their houses in order, the room for monetary manoeuvre will continue to narrow.
These understandable cautions should not translate into inaction. Nowadays, the main contribution of central banks lies in preserving their credibility through a forward guidance that conveys to the markets their unequivocal intention to tackle inflation. Accompanying such proclamations with rate hikes, to make them credible. However, care must be taken to administer the remedy in measured doses that do not worsen the patient.
