Hi there,
Carmel is away this week, so I’m filling in for her and wanted to discuss a debt issue that may be flying under the radar for some.
All the market talk has been focused on U.S. debt hitting $40 trillion this summer, with interest costs rising to over $1 trillion a year as the 10-year yield inches towards 5%. Sure, the U.S. is on an unsustainable path and the Treasury’s efforts to bring down longer-term borrowing costs are likely to prove futile without meaningful fiscal correction. But the U.S. enjoys the exorbitant privilege of issuing the world’s reserve currency in the deepest bond market. Capital keeps flowing in and economic growth remains stellar, driven by massive AI investments. So its debt market may be creaking, but it’s certainly not breaking just yet.
France, the euro zone’s second-biggest economy, may be in a far more precarious position, however.
At 117% of GDP, it has one of the highest debt levels in the developed world and is heading into a tense presidential election in which the frontrunners are hard-left and far-right candidates both pushing expensive platforms. And French governments already have a long history of retreating from reforms in the face of street protests and political pressure.
This lack of economic transformation has left growth below 1%, which makes it essentially impossible for the country to grow out of its debt. Spending meanwhile remains unsustainably high and the budget deficit will again exceed the target this year. Reflecting those troubles, the 10-year French yield, a key gauge of perceived financial health, has risen to around 4.25% this summer, almost double the central bank interest rate.
The regional implications of any capital flight could be massive. Italy, Spain and Belgium all have debt levels in excess of 100% of GDP, so the risk of contagion and turbulence is high. That would then put pressure on the only entity that could restore calm to the euro zone bond market: the European Central Bank.
The ECB has the firepower to calm markets but has so far gone out of its way not to use it. It has spent years reducing its government bond holdings and set tough conditions for any market intervention. Its Transmission Protection Instrument could be used to hoover up debt and push yields back down, but only in case of “unwarranted” market moves.
It is hard to argue that a rise in yields for an indebted country with weak economic fundamentals amid political turmoil is not warranted. France is too big to fail, however, and the ECB could come under pressure to intervene, even if the legal justifications could be questionable.
The spread between 10-year German and French debt, a key indicator of investors’ risk appetite, has been inching up all summer and stands at 87 basis points, above that for Italy and its highest level in years. While it is not yet in the danger zone, it’s clearly moving in the wrong direction, and it may be just a matter of time before the ECB’s resolve is tested again.
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