A top adviser to President Clinton once paid a famous backhanded compliment to fixed income traders. Reflecting on whether he would prefer to be reincarnated as a president, pope or sports star, James Carville said he would choose to come back as the bond market, because ‘you can intimidate everybody’.
The time when bond markets inspired such fear among politicians now seems like a distant memory. But from the 1970s to the 1990s, so-called bond vigilantes roamed global markets, dispensing summary justice to spendthrift governments by jacking up their cost of borrowing and so derailing their plans.
‘The events in the UK are being seen as a canary in the coalmine’
Eurozone next?
While UK markets have subsequently stabilised somewhat, the incident raises a broader dilemma for governments around the world, including the eurozone, where governments are boosting spending to protect their economies from the impact of higher energy prices. The question is now whether such noble efforts to support companies and consumers end up backfiring in the form of higher borrowing costs. This is a particularly pressing question for chief financial officers.
The answer will partly depend on the individual circumstances of the different Eurozone nations, says Andrew Kenningham, chief European economist at Capital Economics. ‘Starting with the broader view, the energy crisis has been a big setback in the efforts to repair government finances after the huge spending required by the Covid-19 pandemic,’ he explains.
As a result, the fiscal deficit for the eurozone, which Capital Economics had expected to roughly halve from its level of 5.1% of GDP in 2021, now looks likely to decline to only around 4% of GDP. While this is still below the 7.1% deficit hit at the nadir of the pandemic in 2020, it compares with a shortfall of less than 1% of GDP in 2019. It is also far above the eurozone’s self-imposed fiscal ceiling, which is meant to limit member nations to borrowing less than 3% of GDP per year.
Wind-down
Now is also a riskier time to borrow. The European Central Bank, which has bought around €5 trillion of government bonds over the past decade to help EU member states cope with various crises, has started to discuss winding down part of this giant stockpile, possibly as soon as the second half of next year. Such sales could come at a time of record bond sales from European governments, with Bank of America expecting an unprecedented €400bn of issuance in 2023, compared with just the €120bn to €145bn expected this year.
The scale of energy support varies considerably from nation to nation. Germany’s traditionally parsimonious government, for example, recently unveiled a €200bn package (around 5% of GDP) – funded by borrowing – to combat rising energy prices out to 2024. Italy’s government, at the time of writing, has committed to around €65bn and France’s to €53bn (3.5% and 2% of GDP respectively), with the tally seemingly rising by the week.
Some of this support is targeted to help specific businesses, including a €15bn bailout for German energy company Uniper. A wider range of companies stand to benefit indirectly from support to citizens in paying for energy bills – without which they would have less to spend on other goods and services.
‘Italy’s Giorgia Meloni has become more insistent on following EU fiscal rules. It seems likely she has half an eye on UK’
Cautionary tale
But the cautionary example of the UK appears already to be changing behaviour. ‘The events in the UK are being seen as a canary in the coalmine,’ Kenningham argues.
The effect is most notable in Italy. Kenningham says: ‘The new government in Italy is made up of these populist right-wing parties, which had very big spending plans in their manifestos. Yet the new prime minister Giorgia Meloni has become more insistent on following EU fiscal rules. It seems likely that she had half an eye on UK.’
Meanwhile, François Villeroy de Galhau, governor of the Bank of France, said the UK example was a lesson to other governments to ensure that fiscal spending is ‘efficient’ and ‘warranted by the present energy crisis’. France, for example, is offsetting much of its rescue package with windfall taxes on energy companies, reducing its need to go to the bond markets for funding.
Germany, too, is providing support on gas prices for only up to 80% of the previous year’s consumption for households; beyond that they will pay the full market price. ‘They are not just putting all of this on the credit card,’ says Kenningham.
Prudence and trust
Assuming governments remain cautious and prudent, Kenningham believes they can avoid the fate of the UK. ‘There is no single metric that determines what a government can get away with before alarming the bond markets – whether this is debt to GDP of the scale of the deficit,’ he says.
Soft factors also matter. Investors are increasingly likely to seek reassurance that any rescue packages are carefully costed and come with a clear plan to bring borrowing back in line.
A lot also comes down to the trust that investors have in certain governments, Kenningham says. Nations seens as having a history of profligate spending, such as Italy and Portugal, could be walking on thin ice with bond investors. By contrast, low-debt countries such as Germany, Austria and the Netherlands have built up huge amounts of goodwill following decades of prudent policy.
Yet, as the UK has just shown, decades of trust can be destroyed with surprising speed.
Accounting for the Future
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