Does rising debt pose a risk for bond markets?
Europe is raising funds in the capital markets mainly in order to support consumers, whereas the objective in the US is to obtain money for infrastructure projects. However, falling energy prices in Europe may lead to a reduction in funding volumes again. What does the packed calendar of new issues mean for fixed-income investors?
With interest rates rising and the major central banks withdrawing liquidity from the market, many governments are turning to the markets to raise funds for their large-scale fiscal programmes. In the eurozone, the planning for 2023 suggests that net new issues will reach a record volume of between €450 billion and €550 billion. By contrast, the US is likely to still have a high budget deficit this year and will spend more money than it earns, leading to a further increase in debt. Added to that, the US Federal Reserve (Fed) is currently trimming its balance sheet (quantitative tightening, QT) by US$ 60 billion per month. And in the long term, there will probably be less demand for US Treasures from countries such as China and Saudi Arabia due to geopolitical reasons.
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Eurozone in middle of the field for debt levels
Outstanding government bonds
Sources: Bloomberg, as at 10 January 2023. * 20 countries including Croatia. -
Eurozone in middle of the field for debt levels
Public debt as a percentage of GDP
Sources: World Debt Monitor, Statista, IMF, European Economic Forecast Autumn 2022, as at 10 January 2023.
Given that Union Investment’s experts anticipate structurally higher levels of interest rates and inflation in the medium to long term, the question for investors is what the implications of the busy issuance schedule are for the markets. Do growing funding volumes, rising debt levels and tighter monetary policy create new risks for financial stability?
Most of the fund-raising rounds scheduled by European countries for 2023 are aimed at funding that will provide relief and support for consumers. But the issuance volumes may not necessarily be implemented in full. The milder the temperatures, the less demand there will be from households for energy, which will probably result in lower levels of government support. This would ease the fiscal outlook for governments and thus reduce the supply of new issues from them over the course of the year.
Moreover, there has been good market take-up for the wave of new issues in the first few weeks of 2023. This suggests a more favourable year for bonds. However, this scenario does not factor in any new external shocks that may arise. And because the fiscal support measures in the EU tend to be aimed at consumers, they have the potential to increase inflationary pressures in the long term, which brings with it higher interest-rate risk.
But what about the ability of countries to service their debt? Unlike the US and Japan, the eurozone does not have one single fiscal policy, so the situation is not comparable. In difficult economic conditions, this ‘shortcoming’ could ramp up the market pressures on issuers with poorer credit quality for a time. Compared with the rest of the world, however, the position of eurozone countries is not too bad, especially as falling energy prices are helping to improve their current account balances (see chart).
After Italy, the biggest (potential) issuer will probably be Germany. It is aiming to raise more than €0.5 trillion in the market in 2023, a significantly higher volume than in previous years. However, the funding volume may end up significantly lower if the energy cost situation continues to ease and growth prospects brighten. In view of the further interest-rate hikes planned by the European Central Bank (ECB) between now and May, Union Investment expects yields on German government bonds to rise a little higher. But at the same time, the increased availability of high-quality, highly liquid government bonds should cause the elevated swap spreads to fall, which would have a positive impact on corporate bonds, covered bonds, and (sub)sovereign, supranational and agency (SSA) bonds.
2. How will balance sheet trimming affect the eurozone’s periphery?
What is the situation for eurozone periphery countries with higher debt levels? The ECB’s hawkish announcement after its December interest-rate meeting was followed by a widening of spreads for bonds from highly indebted countries like Italy. However, they have since narrowed again. In this respect, the ECB’s plans to slim down its balance sheet are an important factor. In March, the central bank intends to stop fully refinancing bonds in its asset purchase programme (APP) when they mature, with an initial volume of €15 billion per month until June. Further details are expected to be provided at the meeting in February. Based on the arithmetic of the current capital key, it seems likely the government bond markets of Italy, Germany and France will shoulder most of the burden of the passive balance sheet reduction.
If the ECB continues with this level of quantitative tightening until the end of 2023, liquidity of around €145 billion would be withdrawn from the market and this could potentially lead to more volatility in the markets. This would take its toll on the bonds of all eurozone periphery countries over the course of the year, but with a particular focus on Italy. Statements from the new government in Rome on the country’s debt policy have been relatively moderate so far.
Although Union Investment’s experts are not anticipating a crisis, they do believe new tensions may arise between Rome and Brussels that could weigh heavily on Italian government bonds. Italy’s government must submit a multi-year finance plan to the EU by the end of April 2023. If it retains the policy of reforms, it will not lose access to EU grants and low-cost loans from the Next Generation EU (NGEU) fund or to any (potential) ECB support.
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Funding requirements of EU countries to rise sharply in 2023
Higher gross deficits as ECB purchases decrease
Sources: Citi, own calculations, as at January 2023. -
Funding requirements of EU countries to rise sharply in 2023
New issues brought forward to Q1 2023
Sources: Citi, own calculations, as at January 2023.
Another reason why Europe is unlikely to see a sovereign debt crisis is that the European Commission, in funding its support programmes (e.g. NGEU), is slowly evolving from a “supranational to a super-sovereign issuer”, to quote Johannes Hahn, Commissioner for Budget and Administration. The EU intends to issue bonds totalling around €80 billion in the first half of the year. These bonds – and the funds raised – will initially go into one shared pot that will then be distributed among the various support programmes. This has a particular bearing on proprietary-account business as the ECB will assign EU bonds the same liquidity status as government bonds with effect from 29 June 2023.
3. USA invests with the aim of limiting inflation
Unlike in the EU, the funds raised by the US in the capital markets will mainly be used for purposes such as infrastructure projects and the strategic restructuring of supply chains rather than to support consumers. In Union Investment’s opinion, this capital expenditure will boost productivity and thus help to stem inflation in the medium to long term. Budget deficits are currently running at high levels owing to the vast fiscal packages. Moreover, negotiations between Republicans and Democrats on raising the debt ceiling are likely to drag on. Nevertheless, Union Investment anticipates that an agreement will be reached in the third quarter, thereby averting a (technical) default.
Overall, the brisk level of issuance activity makes a steepening of the US yield curve more likely. Another contributing factor will be the ongoing streamlining of the Fed’s balance sheet as this is likely to result in a rise in the term premium. One of the headwinds for euro investors will be the weaker US dollar owing to the declining interest-rate differential between the US and the eurozone.
In a nutshell: it’s time for tactics
The wave of new issues that is continuing for now in combination with the uncertain picture for inflation and growth – although this is now looking more positive in many countries – will probably result in bouts of volatility but not prevent a stabilisation of the markets. A sovereign debt crisis as a result of rising interest rates is not expected in developed countries. Fixed-income investors in Europe may show a preference for bonds from countries with a better credit rating. In the medium to long term, what will be important is whether inflation continues to diminish thanks to falling energy prices and, in particular, whether the rise in the core inflation rate eases off. Nonetheless, the higher coupon levels will still provide income and a degree of protection against possible renewed price falls driven by interest rates.
Overall, the interest-rate differential will remain tipped in favour of the eurozone, which means the euro may appreciate further. In the US, the rise in yields will be less pronounced. However, a steepening of the curve (at the long end) appears likely in view of the brisk level of financing activity. In that case, the better expectations for productivity and growth compared with those for Europe suggest that US yields will stabilise in the medium to long term. Japanese yields are predicted to go up in the first instance, with the potential appreciation of the yen proving beneficial to fixed-income investors.
As at 17 January 2023.