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Governments have been borrowing as if there is no tomorrow - and they are going to soon realise how expensive that strategy is, a chief economist has warned.

Ian Stewart, Deloitte's chief economist in the UK, has been poring over debt levels of governments in Europe and North America, and said he thinks Western governments are going to have to dig deeper, for longer, to fund that borrowing.

According to Stewart: "Borrowing is becoming more expensive for western governments".

He pointed to recent figures showing that the interest rate, or yield, on US 30-year government bonds reached 4.96 per cent, the highest level in 16 years.

German bond yields, which are close to 3 per cent, are back to levels last seen during the euro crisis in 2011.

UK 10-year bond yields are higher now than they were at the height of the sell-off in the wake of the mini-budget a year ago.

He said: "Rising borrowing costs partly reflect rising central bank interest rates and a conviction that they are likely to stay at elevated levels for some time.

"The yield on a bond also offers compensation for the risk of unexpected shocks, such as surging government borrowing or higher inflation. Recent strong data from the US, including Friday’s jobs numbers, have added to concerns about inflation.

"At the same time, governments are continuing to borrow on a significant scale."

Conventional wisdom

But he also questioned applying conventional wisdom to what is happening in bond markets right now.

Stewart explained: "High levels of borrowing might be thought to drive interest rates higher. But in recent decades inflation and central bank interest rates have tended to dominate.

"Yields on government bonds trended lower from the early 1980s to 2022 despite rising government borrowing. Yields dipped to an all-time low in the pandemic at a time of surging government borrowing and spending.

"By and large the supply of government debt has not been a major driver of bond yields - and he dynamics are different now."

He pointed out that inflation is "no longer quiescent, as it was during the period of ever-falling bond yields".

And central banks, rather than buying government bonds in an effort to drive down yields, as they did from 2008, are selling them.

Meanwhile, public sector debt levels have ballooned in the past 15 years.

In the US, the ratio of public sector debt to GDP has more than doubled in the past decade, and is higher now than at any time since the early 1940s.

"Put another way, countering the financial crisis and the pandemic has had a greater effect on US debt levels than fighting WW2", he said. 

"Barring an abrupt change of course, public sector debt levels seem likely to keep rising. In the US, where we have long-term official forecasts, the projections are eye watering.

The US Congressional Budget Office estimates that health and welfare costs will outpace US GDP growth, taking public debt from 98 per cent of GDP today to almost 200 per cent in 2053."

Obvious implications

There are three obvious implications for asset allocators from all of this, according to Stewart.

The first is that the public – and governments – will have to get used to paying more to service existing debts. And Debt-financed public spending is less attractive and riskier now than when the UK government could borrow for ten years for almost nothing, as was the case in 2020.

A second implication is that governments face greater scrutiny of their spending and borrowing plans from bond markets.

For example, in September, the Italian government raised the forecast for its deficit this year from 4.5 per cent to 5.3 per cent of GDP, unnerving bond markets and pushing up the premium over Germany required by investors to lend to Italy. 

Pressure from financial markets, in the form of higher rates, is likely to act as an increasing constraint on public spending.

The third implication comes from levels of bond yields. These show that financial markets foresee no return to the low interest rates that were the norm until 2021.

On the contrary, market pricing implies that rates will stay at high levels for years to come. Those expectations may prove wrong, but that is what the bond market is saying. Corporates and households need to adjust to a world of higher rates.   

So will allocators stop buying bonds?

Not according to Stewart, who added: "Markets will doubtless buy this debt, the question is at what price?" And, since the yield is a function of the price, at what yield?

Simoney Kyriakou is editor of sister title FTAdviser