Under pressure: Tracking the pain in G7 government debt

U.S. government debt has surpassed $40 trillion for the first time, highlighting the challenges faced by major economies in financing rising spending needs due to factors like aging populations, climate change, and defense costs. This year, the Iran war reignited inflation risks, while Europe's volatile weather adds further strain to public finances.

U.S. 30-year Treasury yields have climbed to their highest level since 2007, prompting government intervention to control borrowing costs. Japanese borrowing costs are nearing their highest in three decades, and Germany, despite having a relatively lighter debt burden, has also seen its yields surge to levels not seen since 2011.

High debt levels can lead to higher borrowing costs, which in turn can negatively impact living standards by limiting spending and restraining growth. Government bond yields across the Group of Seven (G7) economies have increased since the COVID-19 pandemic and Russia's invasion of Ukraine, as central banks aggressively raised interest rates to combat high inflation.

The widening gap between shorter and longer-term borrowing costs makes it more expensive to borrow for longer periods. Fiscal concerns, central banks reducing bond holdings, and a shift away from traditional investors in long-term debt, such as insurers and pension funds, are further intensifying the pressure. Many governments have started selling shorter-term bonds, but this can be risky as they will have to repay or refinance the debt sooner, and rising yields will quickly feed into interest costs.

Debt in the G7 is at or above the level of their respective economic outputs, except for Germany. The 2008 global financial crisis, the 2011-12 euro zone debt crisis, and the 2020 pandemic all contributed to higher debt levels, which in turn hampered growth. Recently, the Russia-Ukraine war, the Iran war, and extreme heat have further escalated spending needs.

Japan holds the highest debt-to-output ratio, with debt more than double its output, while even Germany, once a champion of austerity, is increasing its borrowing. Factors such as aging populations, interest bills, and increased spending on defense and climate change could further raise debt levels. Higher post-pandemic borrowing costs are contributing to the rising interest payments relative to output for most G7 countries, with the United States seeing a notable increase.

The term premium on U.S. Treasuries, which measures the compensation investors demand for holding longer-term bonds, has risen since the pandemic due to concerns about U.S. fiscal policy, the Federal Reserve's bond holdings reduction, inflation uncertainty, and worries about clear communication under new Federal Reserve Chairman Kevin Warsh.

This global phenomenon is reflected in the fact that the term premium across major OECD countries reached its highest level in over a decade. While some countries are experiencing improved debt metrics, investors are now less willing to accept lower returns on individual euro zone government bonds compared to those of Germany, which is considered Europe's safest borrower.

The European bloc has come a long way from its debt crisis, with growth in European cohesion since the pandemic, political stability, and a lower budget deficit helping reduce Italy's debt risk premium to the lowest since 2008. In contrast, investors have become more wary of French bonds, with their risk premium expected to rise significantly over the next decade unless policymakers act quickly to curb spending.

Japan's 10-year bond yield is nearing 3% for the first time since the mid-1990s, indicating that inflation, rising fiscal concerns, and monetary policy expectations are reshaping a market long dominated by low interest rates. Japan, the most indebted country among the developed nations, is under the microscope as Prime Minister Sanae Takaichi's spending plans reignite fiscal concerns.

The country's debt sales are closely monitored for signs of stress, and yields have risen sharply at bond sales in recent months. The government has tried to stabilize demand by trimming longer-dated bond sales, but borrowing costs continue to face upward pressure. This global quandary raises the question of what will happen if more attractive yields attract Japanese money home, potentially undermining U.S. and European debt markets, which have been pillars for decades.