Why the rise in government debt is freaking out the bond market

Mortgage holders are not the only ones feeling the impact of rising interest rates; governments and businesses are facing the same challenge. In Australia, the government now has to offer investors more than 5% on its 10-year bonds, which reached a 15-year high due to the Reserve Bank of Australia's (RBA) efforts to combat inflation.

Similarly, in the United States, 10-year interest rates have surged to around 4.7%, nearing a two-decade high. As interest rates climb, governments face higher interest payments, leaving less room for other spending or tax cuts. This situation affects not only the federal government but also state governments, with Victoria's 10-year bonds now paying an interest rate of 5.55%.

The drivers behind rising market interest rates are primarily supply and demand. Governments issue bonds to raise funds for spending not covered by tax revenue. Bond issuance comes from three main sources: households, businesses, and governments. In the US, AI-sector firms such as Amazon and Microsoft have issued about US$240 billion in debt to fund data centers.

Australia's Google owner, Alphabet, launched a bond worth A$5.5 billion recently. However, the main driver is government debt. The larger a government's debt, the more bonds it must issue, leading to higher interest rates to attract investors. US national debt is more than US$40 trillion, while Australia's federal government debt recently surpassed A$1 trillion.

These large debts are pushing up interest rates globally. Meanwhile, some bond investors are concerned about the high levels of US government debt and lack of plans to curb spending, leading them to demand higher interest rates on government bonds.

The Reserve Bank of Australia (RBA) manages interest rates through the "cash market," using the cash rate to influence demand for borrowing. Raising interest rates ultimately reduces economic demand and inflation. However, the RBA cannot directly influence longer-term interest rates, such as 10-year bonds, which fluctuate based on investors' demand.

If the RBA cuts rates sharply, bond investors might interpret this as inflationary, pushing up inflation expectations and, consequently, the interest rates demanded on longer-term bonds. The US has long enjoyed an "exorbitant privilege," issuing growing volumes of government bonds without needing to offer higher rates to attract buyers.

This privilege stems from the US dollar's dominance in global trade and financial transactions and widespread trust in US government debt. In an attempt to lower market interest rates, the US Treasury increased the amount of debt it buys back, but the impact was brief. Investors concluded that buybacks don't change the underlying forces: growing US government financing needs, fears of rising inflation, and increasing corporate bond issuance to fund AI and data centers.

All these factors tend to push interest rates higher in the medium to long term, and financial engineering cannot reverse this reality. Across many countries, bond market rates are rising due to higher inflation eroding investors' real returns. They demand more compensation to protect their spending power. This situation is compounded by rising bond issuance from both governments and companies.

No financial engineering from the US Treasury or central banks can reverse these forces. The best way for central banks to keep market interest rates low is to set policy so inflation remains low, as is the RBA's inflation target of 2–3%. By maintaining low inflation expectations, bond investors know that market interest rates shouldn't become too high in the medium term.