For both Canada and the U.S., the all-in cost to service national debt has roughly doubled over five years.Sean Kilpatrick/The Canadian Press
The world is awash with government debt – and those flood waters aren’t going to recede any time soon. Investors may want to ponder what that torrent of borrowing will mean.
The most predictable effect is likely to be a sustained rise in long-term interest rates as markets struggle to accommodate the vast quantities of government bonds hitting the market. To some extent, this rise has already happened. Over the past couple of years, the rates on benchmark 10-year government bonds in Canada, the United States, the United Kingdom and several other developed countries have climbed steadily higher, emphatically ending the low-rate nirvana that existed for much of the 2010s.
These higher rates are likely to endure and could go even higher. Over the long run, they will put pressure on stock prices, because higher-yielding bonds will offer an increasingly attractive alternative for investors.
More ominously, the burden of higher interest rates will slow economic growth. They could even cause financial crises in some countries – particularly in the U.S., where debt is clearly on an unsustainable course.
To be sure, no crisis seems imminent. Still, it’s worth understanding why bond markets are showing flickers of anxiety and demanding substantially higher yields on government debt.
The prime culprit is high and growing amounts of state borrowing. Government debt across the world’s advanced economies has swelled from an average of 103.6 per cent of gross domestic product (GDP) in 2019 to an estimated 110.1 per cent this year, according to the International Monetary Fund. The IMF expects the debt load to continue climbing, reaching 113.3 per cent of GDP by 2030.
Those are troublesome numbers, and what makes them even more troublesome is that governments are now paying far higher interest rates on their debts than they did just a few years back. This toxic combination – borrowing more money and borrowing it at much higher rates – has sent the total bill for interest costs spiralling to intimidating heights. In both Canada and the U.S., the all-in cost of servicing national debt is now roughly double what it was five years ago.
Surging interest payments are crimping other priorities. In Canada, Ottawa will spend nearly as much on interest payments this year as it does on health care. In the U.S., Washington will pay more in interest this year than it will spend on national defence.
Similar trends are evident across many other advanced economies, although there are important differences among them. Canada, despite its mounting interest payments, still looks to be on solid fiscal footing on most measures tracked by the IMF. In contrast, the U.S., France and Japan show no signs of easing back on their debt addictions. They are expected to run massive deficits for years to come.
Could that change? Maybe, but there are good reasons to think most countries will be locked into a high-debt trajectory for years to come. There are simply too many compelling reasons for spending in the here and now.
Consider, for instance, the need for increased military spending at a time when Israel is attacking Iran, Russia and Ukraine are at each other’s throats and the U.S. is walking away from its role as global hegemon. Governments are right to bolster their militaries and are likely to fund much of the required spending through debt.
Many countries are also likely to turn to debt to meet the needs of their aging populations. Good pensions and good health care are praiseworthy things – but they are also fiendishly expensive.
On top of that, many governments are feeling pressure to address housing shortages. In Canada, this need is particularly acute. We need $2-trillion in capital over the next five years to meet our housing needs, according to a recent Royal Bank of Canada report. Governments can’t and won’t fund that directly, but they will be under pressure to come through with generous tax deductions for anything housing-related. In all likelihood, that will stoke increased deficits, at least in the short term.
So when does this all end? Presumably when bond markets rebel and start demanding such sky-high yields that governments are forced to retrench. The U.S., in particular, seems vulnerable. Donald Trump’s One Big Beautiful Bill Act will add trillions of dollars over the next decade to an already massive national debt burden.
Even there, though, markets seem surprisingly tolerant. In a report this week, Paul Ashworth, chief North American economist at Capital Economics, wrote that the risk of a U.S. fiscal crisis is rising, but he argued that it is not an immediate worry. The key, in his view, is what happens to long-term U.S. interest rates. If rates keep rising, investors could lose faith in Washington’s ability to service its debt – at least without resorting to inflation, capital controls or other drastic measures.
“We suspect that a 10-year yield of 5.5 to 6 per cent could be that tipping point,” he wrote. Fortunately, 10-year U.S. yields are still around 4.4 per cent. Investors, though, may want to keep a close eye on where they go over the year ahead.
