The bond vigilantes are closing in

By
BrusselsReport.eu
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By Belgian MEP Johan Van Overtveldt (Belgian Finance Minister between 2014 and 2018, Chairman of the European Parliament’s Budget Committee) 

The downfall of the Bayrou government in France adds to the nervousness that is already racing through the international bond markets. Persistently large budget deficits and relentlessly accumulating public debt really need to be tackled. If not done adequately, the price to be paid will be high.

Shocks

Earlier this year Finnish president Alexander Stubb declared that “our holiday from history is over”. It is indeed an understatement to argue that most European governments and the EU institutions are overwhelmed today by the number and intensity of crises and shocks that we implicitly came to assume as belonging to our past.  First and foremost there is of course the Russian invasion of Ukraine, expressing a brutal boldness of Vladimir Putin’s Russia to become the dominant power on the Eurasian continent. War is back prominently on European agendas. All of a sudden European countries that took US military protection for granted too long have to take their own defenses and military (un) preparedness very seriously.  

“Most European governments and the EU institutions are overwhelmed today by the number and intensity of crises and shocks that we implicitly came to assume as belonging to our past“

The second shock relates to the re-appearance of Donald Trump as president of the United States. Not only is Trump unleashing trade wars that will weigh heavily on the European economy (and on the American one as well), it is apparently also very difficult for him and his staff to hide a fundamental antipathy to, or at least a lack of interest in, all things European. Can the US still be considered a trustworthy partner for Europeans? On paper, the transatlantic alliance is still alive through organizations like NATO but the context of it has become much more delicate, even more counterproductive than it has ever been since the Second World War.

The third shock is the renewed war in the Middle East, with the horrible situation in Gaza increasingly stirring up intense emotions throughout our societies, bringing down the Dutch government and complicating much needed internal policy action for several other EU governments. Add to these shocks ongoing complex and demanding issues such as the demographic aging of the continent, exacerbated by declining birth rates, immigration that is increasingly criticized by various segments of the population, climate change and the unpredictable ways in which artificial intelligence will develop and what will be the broad societal consequences of this spectacular, and unstoppable, technological revolution, and the contours of a continent in deep turmoil are apparent.  

“Incredibly high”

On top of all the above shock and awe there is the ongoing deterioration in the public finance health of several major European countries. This evolution is part of a worldwide rise in government debt levels. Gita Gopinath, the IMF’s outgoing chief economist, recently described the present global public debt levels as  “incredibly high”. Global public debt climbed between 2000 and 2025 from 64% of worldwide GDP to an astonishing 92%. Gopinath forecasts this ratio to go to 100% by 2030 furthermore acknowledging that debt-to-GDP ratios tend to come out “about 10 percentage points – or more- higher than we expected”.

Unsurprisingly given this debt tsunami, government debt service costs have been going up considerably in recent times. For a group of countries like the US, the UK, Japan, Canada, Germany and France long-term interest rates were located in the 0% (Japan) to 2% (US) bracket in 2020, but this bracket has now moved up to 3% (Japan and Germany) and 5.5% (UK). Rising debt service costs are rapidly further complicating the already precarious public finance situation of several countries.

A clear example of this relentless increase in worldwide public debt-to-GDP ratios has been China where this ratio went up from around 25% of GDP in 2000 to 80 to 90% of GDP in 2025. Even more important for international markets was the doubling in the United States of its debt-to-GDP ratio over the same period, i.e. from roughly 60% in 2000 to around 120% in 2025. Against these numbers the public debt situation in the euro area looks at first sight rather benign with the overall debt ratio for the euro area hovering around 90%. But there are important differences between the US and the euro area, up to this point mainly to the disadvantage of the euro area (a characteristic that may change temporarily (?) as a consequence of Donald Trump’s hair-raising actions and declarations).

Basically three elements make up the American advantage.  First, anno 2025 the US still has the advantage of an economy that is growing consistently faster than the euro economy. Real economic growth is an important driver of debt dynamics. Secondly, the overall tax burden is much lower in the US than in euro area countries: government revenue as a % of GDP stands overall at 47% in the euro area while it is 25% in the US. The tax space available to utilize for increased revenues without crippling the economy is in principle much larger in the US than in the euro area.              

Thirdly, and most importantly, the euro area’s institutional framework is still incomplete. We have one central bank, the European Central Bank (ECB), but in other policy areas we lack such a streamlined approach and try to get along with all sorts of ad hoc arrangements and often over-complicated decision-making procedures. With respect to fiscal policy discipline we are supposed to obey the rules on budget deficits and debt evolution of the Stability and Growth Pact but each time the heat turns up we suspend these rules while in normal times the offenders of the rules get away with it all too easily (which is certainly the case for the larger member states).

Paris in the fog

Given these relative disadvantages of the euro area it cannot be a surprise that bond markets are extra mindful of what is happening in the euro area and in its individual member countries. As the second largest economy of the euro area France is unavoidably more in the picture than, say, Malta or Latvia. The recent downfall of the Bayrou government is hence very much on the radar of the so-called bond vigilantes, defined by ECB researchers as “investors who sell off sovereign bonds in times of stress as they punish governments for what they consider to be bad policy choices”.

“As the second largest economy of the euro area France is unavoidably more in the picture than, say, Malta or Latvia”

Bond vigilantes

The term “bond vigilantes” was coined during the early 1980s by economist Ed Yardeni to describe investors who sold off American bonds to protest against what they considered (rightly so) to be the inflation-fueling policies of the Federal Reserve, the American central bank. ECB research discovered international investment funds to be the main actors within the bond vigilantes community. These funds hold in their portfolios up to a quarter of the outstanding public debt of some euro area member states. If they move by re-arranging their portfolios, markets move too.  

France is now clearly on the vigilantes’ radar, as the jump in interest rate spreads (difference with the German reference interest rate) shows. The country’s budget deficit seems stuck in the 5 to 6% of GDP bracket, its debt-to-GDP ratio stands at 113% and is steadily moving further up. Public expenditures in France represent 57% of GDP, one of the highest in the Western world. Prime minister François Bayrou’s government fell over its plan to cut expenditures by 44 billion euro, or 1.5% of GDP. To put these 44 billion euro further into perspective it is informative to refer to the annual debt service cost for France standing now at 66 billion euro, already 50% higher than the proposed and rejected savings package.

The basic political problem in France is that president Macron’s centrist coalition is now far short of a majority.  Moreover, the two main opposition parties – Jean-Luc Mélenchon’s La France Insoumise on the extreme left and Marine Le Pen’s Rassemblement National on the extreme right – are economically two of a kind, more specifically hell-bent on further spending increases. The fact that the French political scene seems to be unable to come to a minimally decent budgetary policy is unnerving bond markets, and most certainly making the vigilante compartment of it extra nervous and jittery. 

Layer upon layer

The bond market is by far the most important of all the international financial markets. Something close to $100 trillion is percolating through this bond market. The US Treasuries market represents around 30% of the entire bond market and is considered to be the bedrock of the international financial system. Unease and nervousness is running high in this international bond market because risks and uncertainty are significantly rising.   

First there is the simple fact, as documented above, that debt volumes that need be financed are not only rising fast nominally but also as a percentage of GDP. In the euro area for example the total financing needs of all the member states (i.e. fresh deficits plus the re-financing of outstanding debt) will be above 1 000 billion euro annually in 2025 as well as 2026. Too much of a good thing (offering relatively safe assets to financial markets) can turn into a bad thing.

“Too much of a good thing (offering relatively safe assets to financial markets) can turn into a bad thing”

Secondly there is the Trump factor. The American president is very creative in opening venues that unnerve bond traders considerably. The idea of taxing foreigners holding US Treasuries has electrified markets. It seems to be collecting dust now but given Trump’s volatility there is widespread fear that tomorrow it may be back on the table. The president is also vehemently attacking the Federal Reserve and its independence, another reason for deep concern as is also Trump’s grandiose fiscal policy that is jacking up budget deficits and debt ratios as far as the eye can see.

Thirdly, seasoned bond traders don’t like the smell of bubble-like excesses in financial markets. That smell is today undoubtedly around. The crypto craze that we see all around us is a prime example of such a bubble that unnerves more traditional bond traders. Another focal point of attention in today’s financial markets is the extraordinary growth of private credit, i.e. the growth of credit extended by non-bank entities. Not only is there a lot of uncertainty of how large this credit bubble really is, even more uncertainty exists as to the extent of the traditional banking sector’s involvement in this private credit market.

Last but not least there is the reality of many Western governments, faced with massive future expenditure increases not least because of the unfunded liabilities in most pension systems, apparently not capable of even a minimum of responsible fiscal policy. The United States needs to be counted in this high-risk group as well as several European countries of which France is the most prominent one. Eurostat data show France to be facing unfunded future pension liabilities to the tune of 400% of GDP. It’s small comfort for Paris that Spain, Austria, Italy and Greece are even still higher up in the unfunded stratosphere.

The conclusion to be drawn today is that policymakers find themselves tiptoeing through a minefield. One faux pas can lead to a deadly explosion. We still might take several faux pas without them resulting in a new major financial crisis. We just don’t know but we have to realize that in the present uncertain and volatile context the chances of the next faux pas becoming the fatal one are increasing day by day.

 

Originally published on the blog of Johan Van Overtveldt. 

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