Bond vigilantes are usually associated with moments of panic, when investors lose confidence in a government’s fiscal strategy, sell its debt and force policy-makers into a rapid retreat. This time, however, their influence may be felt less through a single market revolt than through a gradual repricing of long-term borrowing.
Governments may find that debt remains more expensive, auctions become less predictable and investors demand greater compensation to hold long-dated bonds. As maturing debt is refinanced at higher rates, interest costs will absorb more public revenue and narrow the room for policy choices.
These were the central themes of the second discussion in OMFIF’s Money Disrupted series, which considered whether the recent increase in bond yields is a temporary response to geopolitical and economic uncertainty or evidence of a more lasting change in the cost of capital. While yields will continue to fluctuate, several of the forces behind their rise appear structural.
Repricing long-term risk
Much of the increase in long-term yields has reflected higher real interest rates rather than a sharp rise in long-term inflation expectations. Investors are not simply anticipating the next few central bank decisions but are reassessing the compensation required to hold government debt over the next decade.
Before the pandemic, falling real rates and term premia supported bonds, equities, property and other long-duration assets. Governments borrowed cheaply, valuations rose and fiscal expansion appeared less costly. Those conditions have weakened as debt issuance has increased and uncertainty over inflation, fiscal policy and geopolitics has grown. As a result, investors are demanding more compensation for committing capital over long periods.
This repricing is visible across the US, UK, euro area and Japan, although the circumstances of each market differ. Governments and businesses are prioritising resilience and security over efficiency, duplicating supply chains, increasing defence budgets and investing in energy security. These choices may be justified by national security concerns, but they come with higher costs.
The globalisation of the post-cold war period helped reduce production costs and suppress inflation. A more fragmented economy is likely to exert pressure in the opposite direction, particularly as geopolitical conflict disrupts trade and energy markets.
Artificial intelligence is adding to the demand for capital. It may eventually deliver substantial productivity gains, but the immediate investment cycle requires data centres, electricity networks, semiconductor plants and other infrastructure. Technology companies are therefore competing with governments for long-term funding when sovereign issuance is already elevated.
More debt, fewer natural buyers
The supply of government debt is likely to remain high. Several advanced economies continue to run large deficits years after the pandemic and subsequent energy shocks, suggesting that borrowing increasingly reflects permanent commitments rather than temporary emergency measures. Ageing populations, healthcare, defence and industrial policy are all anticipated to add to these pressures – governments should refinance debt issued when interest rates were much lower.
Some of the most dependable buyers are becoming less able or willing to absorb additional issuance. Foreign reserve accumulation once provided strong support for US Treasuries during the early 2000s, but this has slowed down in recent years. Central banks and insurance companies remain stable investors, although their balance sheets cannot expand indefinitely.
The UK faces a particularly difficult adjustment. Defined benefit pension schemes were natural buyers of long-dated gilts because these assets matched their liabilities. As those schemes mature and shrink, they are being replaced by defined contribution funds that tend to favour equities and other growth assets. This leaves the UK more dependent on foreign investors, who compare returns across markets and are more sensitive to inflation, currency risk and fiscal credibility. Attracting them is likely to require higher yields, while their demand may prove less reliable during periods of stress.
Banks are sometimes presented as an alternative source of demand, but relying on them to absorb more sovereign debt would create new risks. Government bonds may carry little credit risk in domestic currency terms, but their market value can fall sharply when interest rates rise. Recent banking stress has already demonstrated the danger of treating long-dated government bonds as though they were equivalent to cash.
Japan may also reshape global demand, as Japanese government bond yields rise from extremely low levels, domestic assets become more attractive to Japanese banks, insurers and pension funds. Even a gradual repatriation of capital could reduce demand for US and European debt and add further upward pressure to global yields.
Discipline without a crisis
None of this makes a disorderly bond market crisis inevitable. Governments can still reduce deficits, improve debt management and develop more stable domestic investor bases. What they cannot safely assume is that central banks will suppress borrowing costs indefinitely or that investors will absorb rising debt without demanding greater compensation.
Bond vigilantes may therefore return through a persistently higher term premium rather than a sudden attack. Their discipline would be visible in refinancing costs, interest bills and increasingly difficult choices over taxation and spending. By the time those choices become unavoidable, the bond market may already have been enforcing them for years.
Yara Aziz is Senior Economist at OMFIF.
Interested in this topic? Subscribe to OMFIF’s newsletter for more.
Leave a comment