Red light in the bond market

If government debt keeps growing faster than the economy expands, servicing it will eventually become impossible.

via Alamy

The Bank for International Settlements is often dubbed the central banker’s central bank. Its default job is to fret about government borrowing, and in a valedictory commentary this week, Claudio Borio, head of BIS monetary and economics, described this as the greatest threat facing the world’s economy. It’s not so much the sheer size - approaching £100 trillion, reckons the IMF - but the seeming inability of states almost everywhere to stop its inexorable rise.

He warned that if governments “wait for markets to wake up it is going to be too late.” Well, plenty of central bankers have cried wolf in the past, and despite moments of panic, the wolf has either not turned up or failed to blow the house down. And Borio is hardly likely to say that he leaves with the house looking in fine shape.

So what does he mean? It is a feature of bond markets that everything goes along normally, until it doesn’t. Britain has plenty of examples of this, from the buyers’ strike in 1976, which forced the Labour government to pay over 15 per cent to borrow for 20 years, to the doomed experiment with Trussenomics.

Before it is too late, there are usually some signs of trouble ahead. Here’s one: At Pimco, the biggest bond fund in the world, chief investment officer of non-traditional strategies Marc Seidner and portfolio manager Pramol Dhawan signalled this week that they were cutting holdings of long-dated US debt. They expect this year’s $1.7 trillion deficit to be eclipsed next year under the Trump administration and there is no credible plan to bring it down.

The US can run big deficits because the dollar is the world’s currency. This is really faute de mieux since there is no realistic alternative, although the spectacular rise this year of gold and bitcoin signals that plenty of investors are looking for one. The Swiss franc is so popular that its central bank seems likely to cut its base rate to zero in time for Christmas.

For currencies like sterling, government bond prices are largely set internationally off the dollar. This is hardly “the kindness of strangers” as Mark Carney foolishly remarked during his unhappy tenure as Bank of England governor, but because the buyers of UK gilts expect to make money. It seems unlikely that we face an imminent buyers’ strike, despite the relentless creation of yet more debt. It’s much more likely that buyers will keep demanding a little more interest to buy the next issue, so that the cost of servicing the debt looms ever larger in the public finances.

The logic here is inexorable. If the debt keeps growing faster than the economy expands, servicing it will eventually become impossible. More borrowing at higher interest rates is a combination toxic enough to bring down a government, or at least force a humiliating policy change. The markets will sense this before it happens, which is why Pimco is cutting back on US long-dated bonds, those which are most sensitive to changes in economic conditions. With a big-spending administration about to take power there, and a government here that seems quite incapable of understanding how and why growth happens, the prudent investor might follow the lead from Pimco.