Crises have passed, expenses remain
To overcome the Covid crisis, usual financial tools were used, only on a much larger scale. Central banks’ balance sheets expanded more, and government spending increased even further. The problem is that after the crisis ended, consolidation in government budgets did not occur, and expenses remained at an elevated level and were increased even more each year.
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The first signal was in 2022, when interest rates climbed out of the negative zone and jumped to 3-4 percent in Europe and the USA. However, historically speaking, they were not very high and it was expected that after the Covid inflation shock, the situation would stabilize, and markets would return to the long-term inflation targets announced by central banks – 2 percent.
Cheap money is over
It is now stated that inflation is still too high and central banks have been unable to achieve the 2 percent target for quite some time (although Europe had reached this target before the Iran conflict). Markets are beginning to factor in more interest rate hikes, and governments face higher refinancing costs for loans.
The most impressive this year was the rise in Japan’s interest rates. The 10-year bond yields rose from 2 percent to 3 percent, and the 30-year from 3.4 percent to 4 percent. These are the highest interest rates since 1994 that the country must pay to secure long-term financing. This is the price for a sharp increase in budget spending aimed at stimulating the economy, and a VAT reduction on food, intended to help residents partially offset price increases.
The situation in the USA is no better – 10 and 30-year bond yields jumped to 4.75-5.25 percent. Debt servicing costs have already become higher than the national defense budget. To control the rise in long-term bond yields, borrowing in the market is done exclusively for short periods, but this only postpones the problem. The budget deficit remains high – about 6 percent of the planned 2026 gross domestic product.
Even Germany finds borrowing expensive
The euro interest rates are most relevant to us. If at the beginning of the year the market expected the European Central Bank not to change interbank interest rates and for them to remain at 2 percent, the situation has now changed significantly. Markets already factor in that short-term interest rates will jump from 2.25 percent to 3 percent over the next year. However, raising interbank interest rates to 3 percent is unlikely, considering that the growth rate of the European economy remains low, but an increase of 0.25-0.5 percent is quite realistic. Long-term bond yields have also risen.
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Germany’s 10 and 30-year bond yields rose to 3.3-3.8 percent and are the highest since 2010. Meanwhile, France, facing bigger budget deficit problems, has even higher debt costs. For 10 and 30-year bonds, this country must now pay 4.25-5 percent interest.
The problem in Europe is that for a long time Germany was like a defender of fiscal discipline, but this year it also started increasing budget spending, and deficit growth is expected both this year and next.
A signal to countries – borrowing will become more expensive
Markets send a clear signal to countries – to borrow more, they will have to pay higher interest rates. Competition for capital in the markets is increasing. Large companies involved in the “cost race” of artificial intelligence also contribute to this competition. The golden era when increasing debt kept interest rates low is now over.
How much will interest rates rise? Probably until concrete actions are taken to control government debts and inflation. Also, the market direction could change again if ships start freely sailing through the Strait of Hormuz.
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