As a result, governments are committing to significantly higher spending on defense, energy security, industrial policy and technology, while at the same time trying to protect households from the rising cost of living. These commitments put new pressure on public finances, which were already strained by borrowing during the pandemic.Fiscal pressures are increasing in the United States as President Donald Trump has proposed a substantial increase in defense spending, which would further widen the federal budget deficit, which is already at a high level relative to GDP. According to data from the U.S. Treasury Department and the Congressional Budget Office, the deficit remains at levels last seen during major crisis periods.
In Europe, Germany has taken a historic step by relaxing the long-standing constitutional ‘debt brake’, allowing sharply higher borrowing to finance defense and infrastructure. According to a report from the Financial Times, new German borrowing related to defense and investment programs could approach €200 billion this year, a shift that has already pushed German bond yields to multi-year highs and caused volatility in European government bond markets.
Japan represents another major pressure point. After a landslide election victory, Prime Minister Sanae Takaichi has outlined major fiscal stimulus plans, including large supplementary budgets aimed at boosting economic growth, military spending and energy security. Much of this expansion will be financed by new debt issuance, at a time when Japan’s public debt-to-GDP ratio is already among the highest in the developed world.
As debt levels, deficits and long-term interest rates rise simultaneously in major economies, investors are beginning to demand higher compensation to accommodate the growing supply of government bonds. Market analysts quoted by the Financial Times warn that this combination increases the risk of continued upward pressure on yields as investor appetite struggles to keep pace with issuance.Central banks are taking a step back
An important difference with previous periods of fiscal stress is that central banks no longer act as aggressive buyers of government debt. According to central bank disclosures, the Federal Reserve, the European Central Bank and the Bank of England are all reducing their balance sheets. The Bank of Japan has also scaled back its bond purchases since 2024.
This shift removes a critical source of demand that previously helped suppress interest rates and stabilize markets. As quantitative tightening gets underway, governments are increasingly reliant on private investors to finance deficits, leaving bond markets more directly exposed to fiscal sustainability concerns.
To control rising borrowing costs, many governments are shortening the term of new debt issuance by relying more heavily on short-term accounts. While this approach limits immediate interest costs and reduces maturity risk for investors, it also increases rollover risk by requiring governments to refinance a larger portion of their debt more frequently, making them vulnerable to shifts in market sentiment.
Fiscal consolidation seems unlikely
The prevailing policy assumption is that higher borrowing will generate sufficient economic growth to stabilize the debt ratio over time. However, analysts warn that this outcome is far from guaranteed. In a recent note, economists at HSBC warned that without a significant rebound in nominal growth, many countries could face difficult fiscal consolidation challenges.
Estimates from HSBC suggest that stabilizing debt ratios under current interest rate conditions would require fiscal adjustments of more than 4% of GDP in the United States, around 3% in France and roughly 2% in the United Kingdom and Germany. Historical data shows that consolidations of this magnitude are rare in advanced economies, making the likelihood of meaningful fiscal tightening in the near term slim.
The Financial Times analysis also shows that such large-scale consolidation efforts have occurred only a handful of times since 1990, usually in response to acute crises – and not during periods of relative economic stability like today.
Implications for investors
While extreme outcomes such as currency depreciation or runaway inflation remain the subject of debate, the short-term outlook for bond markets appears structurally more challenging. Higher issuance, reduced central bank support and increasing geopolitical risk are likely to keep fixed income markets under pressure.
This environment also raises questions about the sustainability of traditional asset allocation frameworks. Market strategists quoted by Bloomberg and Financial Times note that the bond component of the classic 60/40 stock-bond portfolio may no longer provide the same level of diversification and stability that investors have relied on for decades.
In an increasingly fragmented global economy marked by fiscal expansion and geopolitical uncertainty, fixed income investors may be forced to reconsider not only how much they allocate to bonds, but also which segments of the bond market offer the least unattractive risk-return tradeoffs.
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