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Government bond yields rose again this week (and so bond prices fell). This is, of course, pushing up government borrowing costs and adding to (already high) deficit pressures. Some thoughts on this:
- In a bull market: equities up, bonds down is not an unusual outcome. The two investments are supposed to complement each other. Better growth means more demand for borrowing and keeps inflation up. This in turn keeps interest rates higher. So, as long as the economy remains in a good place and interest rate rises are controlled (as they have been recently) then what we are seeing today is actually not that unusual.
- That said, if you are a small business owner, a private equity investor or a mortgage borrower then higher rates are bad. And, as I mentioned at the start, there is also the risk that rising borrowing costs push government debt levels higher, which pushes the deficit higher and so pushes interest rates even higher (as investors demand a higher return for taking on more risk). And you can see this effect pretty clearly in the UK. In 2021 it cost the UK less than 1% to borrow for 10 years. Now that cost is over 5%. The UK government has, of course, raised taxes. But the depressing part here is that those higher taxes have, so far, just offset the rising borrowing costs. So, the deficit is pretty much unchanged since Labour took power in 2024:
- But if you are an investor (which clients of IPS of course are) then this is not all bad news. Those higher borrowing costs are your higher bond returns. Short term investment grade credit yields are back above 5%. And they* have generated a pretty steady 5.2% per annum return for the last 3 years, which is 2% above CPI inflation which has averaged 3.2% over the same period. So that is inflation +2% for not taking a huge amount of risk. With today’s higher bond yields, that risk reward vs inflation looks pretty attractive to me looking forward.
- What about some sort of debt doom loop where governments become insolvent and/or we end up in some sort of inflationary apocalypse? I have a hard time getting too excited about this for governments (like the UK, US and Japan) that borrow in their own currencies. US debt is (literally) repaid via electronic double-entry bookkeeping on the Federal Reserve’s ledger. As long as their computers are running, you will get your money back. And the inflation outlook remains, I think, relatively benign, especially after you allow for the oil and tariff shock markets are still digesting. This is adding around 1% to today’s US inflation rates and is expected to fall away over the next 12 months:
- This does not mean some very well-respected people are not more bearish on all this than me. They may turn out to be right! But there has been a chorus of people warning about debt levels since Japan’s borrowing took off in the 1990s. This has, on average, been a money losing view. This week I saw Ray Dalio (the billionaire founder of Bridgewater Associates, a hedge fund) was quoted as saying:
“Yes, we are past the point of no return. When debt service payments squeeze out spending, it is like plaque in the circulatory system squeezing out the flow of blood.”
Before you have that heart attack, here is Ray Dalio warning about pretty much the same thing, but back in 1982:
- But if governments borrow and spend too much (as many are doing today) there has to be a price. Higher borrowing rates and higher taxes to pay for them are, of course, the main ones. But for investors, currency markets can play a role. This week, the US Treasury intervened in bond markets in an effort to cap longer-term US yields. This is something Japan has done on and off for a long time. But even with a cap, investors still want those higher yields to compensate for the higher risks involved. This puts pressure on the dollar and the yen: one way to boost returns in the future is to make the currency weaker today. The Japanese Yen is already at historic low levels. And this week the US dollar fell in response to the treasury intervention. Sterling at 1.36 to the dollar is back near its post-Covid highs.
- I am not (yet) overly worried about the higher yields we see today. The global economy is doing well and there are good reasons for higher yields such as the ongoing AI investment boom. But if I was more bearish, I think avoiding the currencies of the problem countries is a good way to manage the risk. In this light, there are plenty of emerging market countries with far healthier debt and deficit positions than the US, Eurozone and Japan. Emerging market debt, and in particular local currency debt, looks like a pretty attractive diversifying asset to me today.
* The returns quoted here are for iShares Core £ Corp Bond UCITS ETF
Chris Brown, CIO
cbrown@ipscap.com
The value of investments may fall as well as rise and you may not get back all capital invested. Past Performance is not a guide to future performance and should not be relied upon. Nothing in this market commentary should be read as or constitutes investment advice.
