Under pressure: Tracking the pain in G7 government debt

The United States has reached the historic milestone of a $40 trillion government debt burden, highlighting the mounting pressures on the world's leading economies to support rising spending demands stemming from aging populations, climate change impacts, and defense requirements. The recent Iran war has reignited inflation risks, while Europe's increasingly unpredictable weather patterns add further strain to public finances.

Consequently, the U.S. 30-year Treasury yields have surged to their highest level since 2007, prompting government intervention to control escalating borrowing costs. Japanese borrowing costs are also near their highest in three decades, while Germany, despite having a lighter debt load, has seen its yields jump to the highest levels since 2011.

Elevated government debt burdens can lead to higher borrowing costs, which in turn harms living standards by constraining spending and capping growth. Sovereign debt serves as the benchmark for borrowing costs for companies and various other loans, including household mortgages. In a worst-case scenario, a country may hit a wall and struggle to service its debt.

Government bond yields across the Group of Seven (G7) advanced economies have surged following the COVID-19 pandemic and Russia's invasion of Ukraine, as central banks aggressively raised interest rates to combat soaring inflation. Higher borrowing costs are also driven by investors' desire for better returns to compensate for the risk of holding debt.

The gap between shorter and longer-dated government bond yields has widened significantly, making borrowing more expensive over longer periods. Fiscal concerns, central banks reducing bond holdings, and traditional investors, such as insurers and pension funds, reducing their purchases of long-term debt have intensified the pressure.

To alleviate the impact, many governments have begun selling bonds with shorter maturities; however, this approach also carries risks as they must repay or refinance the debt sooner, causing any rise in yields to affect interest costs more rapidly. Across the G7, debt levels are roughly equal to or higher than economic output, with the exception of Germany, Europe's largest economy.

The 2008 global financial crisis, the 2011-12 euro zone debt crisis, and the 2020 pandemic all contributed to increased debt levels, which have subsequently hampered growth. The Russia-Ukraine war, the Iran war, and extreme heat events have further exacerbated spending needs. Japan bears the highest debt-to-output ratio, with debt more than double its economic output, while even Germany, once known for its austerity policies, is increasing its borrowing.

Germany's finance ministry attributes the rising funding needs for substantial defense investments to Russian aggression, which is pushing borrowing costs higher. As aging populations, interest bills, and increased spending on defense and climate change could further elevate debt levels, higher post-pandemic borrowing costs are feeding into governments' interest payments.

Although interest payments as a share of output are still well below historical peaks for many countries, they have steadily risen across most G7 nations, notably in the United States. Interest payments across OECD countries, including the U.S., already surpassed defense spending in 2024. The term premium on U.S. Treasuries, a key indicator of the compensation investors demand for holding longer-term bonds, has risen since the pandemic.

This rise reflects factors such as concerns about U.S. fiscal policy, the Federal Reserve's reduction of bond holdings, long-term inflation uncertainty, and worries about clarity in communication under new Federal Reserve Chairman Kevin Warsh. This global phenomenon is evident in the fact that the term premium across major OECD countries reached its highest level in over ten years, according to the organization's recent findings.

While some debt metrics have improved, investors are now less willing to accept lower returns on individual euro zone government bonds compared to those of Germany, considered Europe's safest borrower. The bloc has come a long way from its debt crisis, when Greece required a bailout and the risk of a euro zone breakup sent borrowing costs soaring.

For instance, Italy's debt risk premium has fallen to the lowest level since 2008 due to growing European cohesion, post-pandemic political stability, and a reduced budget deficit. However, France, which faces a critical election next year, faces a sharp deterioration in its public finances over the next decade unless policymakers act swiftly to curb spending.

An independent government-commissioned report released in July warns of this risk. Japan's benchmark 10-year bond yield is on the brink of reaching 3% for the first time since the mid-1990s, reflecting how inflation, rising fiscal concerns, and monetary policy expectations are transforming a market historically defined by low interest rates.

Japan, the world's most indebted developed country, is under scrutiny due to Prime Minister Sanae Takaichi's spending plans, which have reignited fiscal concerns. The nation's bond sales have attracted attention for signs of stress, and yields have risen sharply during recent bond sales. While Japan has trimmed longer-dated bond sales in response, helping to stabilize demand, borrowing costs still face upward pressure.

This global situation presents a dilemma: if more attractive yields attract Japanese money home, a critical support pillar for U.S. and European debt markets could crumble.