The bond market has spectacularly turned upward in the developed world, pushing yields down and perhaps too quickly forgetting about the soaring budget deficits.

In the coming weeks, the governments of the United States, the United Kingdom, and the Eurozone will start flooding the market with bonds at a rate rarely seen before. Faced with bloated deficits that were once unthinkable, these countries will sell a net $2.1 trillion in new bonds to finance their spending plans for 2024, a 7% increase from last year.

While most central banks are no longer buying bonds, attempting to limit the size of their balance sheets, governments now need to attract investors worldwide. To do this, they will have to offer higher yields, just as they did when concerns about the explosion of public debt were amplified this summer by Fitch Ratings’ decision to strip the United States of its AAA credit rating. The resulting turmoil pushed the yield on the 10-year Treasury above 5% for the first time in 16 years.

This nervousness has subsided, mainly because inflation has slowed, and the FED has more or less signalled the end of the rate-hiking cycle. As is often the case, the market focuses on one idea at a time. And for now, the market is obsessed with the Fed’s rate cycle. Soon enough, deficit issues will resurface, promising volatility. To put it in perspective, public debt in advanced economies has risen to over 112% of GDP, compared to about 75% twenty years ago, according to IMF data.

It is difficult to determine how much this growing debt pushes up borrowing costs. A few years ago, researchers from the Bank of England and Harvard University demonstrated through empirical study that every one percentage point increase in a country’s debt-to-GDP ratio raises market rates by 0.35 percentage points.
These calculations certainly haven’t worked this way in recent years. Treasury yields, for example, have fallen in this century as the US debt-to-GDP ratio has increased. However, the study should be taken into consideration. As the United States now records annual deficits equal to 6% of GDP, roughly double the historical norm, some analysts believe this will add an additional percentage point to yields. Not only would this swell the government’s interest bill and further widen the deficit, creating a vicious circle, but it would also push up borrowing costs for businesses and consumers and slow economic growth.

Public finances are less bleak elsewhere, but countries like the UK, Italy, and France are all expected to post higher-than-normal deficits again this year. And a slew of elections this year will not push for a debt slowdown.