Growing debt, stubborn inflation, unsettled markets – how the new world of interest rates is eating into the global economy and endangering financial stability. Particularly affected once again: Europe.
Rising bond yields are putting financial markets worldwide under pressure and putting countries' high levels of debt to the test. The USA in particular is becoming the focus of concern - with consequences far beyond the bond market.
The following sections explain how the new world of interest rates is affecting Europe and the USA, why confidence in US financial policy is waning and which factors are driving yields further higher.
You can read why the phase of low interest rates is over and what consequences rising yields have for highly indebted countries, the ECB and the financial markets in the Handelsblatt interview with Clemens Fuest.
Berlin. Mohamed El-Erian is something like the bond economist among American economists. Nobody knows the international bond markets better, and hardly anyone has the great talent to explain the complexity of the bond markets in such catchy terms as he does.
The US economist also gave a sample of his creativity this week. “It’s our debt, but it’s your problem,” El-Erian said on the “One Decision” podcast. He was referring to the legendary saying of former US Treasury Secretary John Connally in 1971, when the United States unilaterally removed the dollar's peg to gold and shook the global monetary system.
What the economist means with reference to the current situation: “America is exporting its debt crisis” – and that is a pretty mild description of what has been going on in the bond markets in the past few days and weeks.
Financial market players are now describing the steep rise in long-term capital market interest rates as a “bond earthquake”. Government bond yields in many parts of the world broke through critical levels - and at breathtaking speed. The ten-year US bond, something of a benchmark for global credit markets, jumped the five percent hurdle and is now at more than 5.33 percent, the highest level in almost 25 years. The German equivalent is now 3.5 percent. France and Italy have to serve their bond investors with 4.9 and 4.7 percent respectively. For American bonds with a 30-year term, the six percent mark is within sight.
» Read also: Yields on US bonds near their highest level since 2002 – auction can only slow the increase for a short time
The largest bond market in the world is triggering a wave movement that is no longer limited to the international bond markets. Mortgages, leasing contracts, corporate bonds, classic corporate loans – there is no area in which interest rates have not risen sharply in the past few days.
A new era of interest rates is dawning
The dynamism and breadth of this development are an unmistakable sign that a new era is dawning: an era in which capital once again has a price; an era that marks the final end of a decade and a half of low interest rates.
Of course, this interest rate turnaround on the capital markets can be interpreted as a return to historical normality after an unprecedented phase of zero interest rates that began with the outbreak of the financial crisis in 2008. And yet it is also a change in epoch with huge consequences. “Countries around the world have taken on more and more debt,” says Princeton economist Markus Brunnermeier. This whole debt situation is “unsustainable in the long term”.
“There is a threat of a new debt crisis,” says Harvard economist Kenneth Rogoff. Bond investors are becoming “increasingly suspicious of the global flood of debt.”
When interest no longer accrues, debt of any amount becomes affordable, politicians and economists alike argued during the low interest rate phase. The saving state rose up, the crisis packages could not be big enough, no matter what the crisis was: financial crisis, euro crisis, pandemic, war in Ukraine. There have always been arguments for new rescue operations. The result of this policy is reflected in the debt levels, which have reached historic dimensions during the low interest rate phase - especially in the industrialized countries.
While the debt ratio of the large industrialized countries (G7) was on average around 78 percent of economic output before the financial crisis, it is now around 124 percent. Of course, the US national debt mountain, which just exceeded $40 trillion for the first time, is particularly impressive. And yet the situation is once again particularly critical in Europe. Ifo boss Clemens Fuest even expects a “return of the euro crisis”. “This time France is the focus,” the economist told Handelsblatt. In fact, France has long since replaced Italy as the most indebted country in absolute terms, with a national debt of more than 3.5 trillion euros (almost 120 percent of gross domestic product). Together they represent 47 percent of the total euro national debt.
However, there is no trace of austerity or reform efforts in France. On the contrary: every attempt at reform by the government, no matter how small, results in massive street protests. “Compared to what we are currently seeing with French bonds, the last euro crisis was child’s play,” said Philipp Freise, co-European head of private equity at KKR, on Wednesday at the German summit organized by “Wirtschaftswoche” and Handelsblatt in Berlin. He justified this solely with the size of France compared to the then Euro crisis countries Portugal, Ireland, Greece and Spain (PIGS).
France
Emmanuel Macron in debt trap
But the other major European economies, with the exception of Germany, did nothing to rehabilitate their public finances during the low interest rate phase. Now this negligent attitude is taking its toll; the interest burden in the budgets of many countries is already overwhelming. "The debt is sustainable as long as investors do not lose trust. But this trust is currently eroding," says Fuest.
Government budgets are still benefiting from government bonds issued at low interest rates in recent years. But as old debts expire and the need to refinance them at significantly worse conditions increases the burden. The yield on French bonds is now almost 1.5 percentage points higher than the yield on federal bonds. Great Britain currently pays the most in Europe at 5.5 percent.
“The UK is particularly at risk,” says Rogoff. Unlike France, which is struggling with even higher levels of debt, “it cannot rely on economically stronger Germany.” In addition, the extensive rescue instruments of a European Central Bank or the EU Commission are not available to Great Britain.
Brunnermeier mentions another key point that distinguishes the current crisis from the financial crisis. During the financial crisis there was still joint crisis management. Today, however, “the G20 countries can no longer agree on a common policy, i.e. on coordinated countermeasures,” he warns. This is “a huge problem that is completely underestimated”.
Doubts about the USA are growing
In general, trust in state institutions to carry out efficient crisis management has suffered in recent years. This applies not only, but especially in the USA, the epicenter of the bond earthquake.
On the other hand, there is the debt policy, which has reached a whole new dimension under President Donald Trump: Despite record high levels of debt, the government is still running budget deficits of around six percent.
On the other hand, there is an attempt to make this debt burden bearable through government intervention. On the one hand, US Treasury Secretary Scott Bessent has recently started buying back long-term government bonds in order to replace them with short-term securities. This means that the government initially receives more favorable financing conditions, but at the price of greater interest rate risk. Because rising interest rates, as can now be observed almost daily on the bond markets, affect the budget much more quickly.
At almost a trillion dollars a year, debt service is already the second largest item in the current budget, after social spending and ahead of defense.
Kevin Warsh: The Fed chief is under political pressure. The debate over the independence of the US Federal Reserve is exacerbating concerns about US financial policy. Photo: Bloomberg
On the other hand - and economists like Rogoff consider this to be even more explosive - the president continues to put pressure on Kevin Warsh, whom Trump installed as head of the US Federal Reserve, to lower interest rates. However, this contradicts the Fed's mandate to combat inflation. The independence of the world's most important central bank is at stake. That alone is an alarming signal for an economy that has been living well beyond its means for decades thanks to the dollar privilege and is more dependent than ever on foreign capital.
The US government's most recent yen interventions also show how great the need is in Washington. Japan, the largest U.S. creditor, recently considered divesting from part of its more than $1 trillion portfolio to support its currency. Bessent eventually intervened in favor of the yen, just to prevent Japan from throwing US bonds onto the market. Because that would drive up yields on US government bonds further.
The fact that the situation is becoming more critical is shown by the auctions of American long-term bonds, which are no longer a sure-fire success for the USA, the reserve currency country. Foreign demand for US bonds has been declining for years. International investors now only hold around 30 percent of US government bonds, compared to 50 percent in 2015. China has almost halved its portfolio to now $618 billion.
So the need is great in Washington, because the largest economy, with a current account deficit of $1.1 trillion, is urgently dependent on foreign capital to finance its prosperity. There is also a correspondingly high willingness to consider unconventional actions.
The pressure on the US financial markets is growing on the New York Stock Exchange: Foreign investors are increasingly holding back on US government bonds. Photo: REUTERS
Putting pressure on other countries in terms of customs and security policy so that they buy US government bonds, or even urging them to exchange existing securities for low-interest “Century Bonds” (keyword: Mar-a-Lago accord): Trump’s former economic advisor once wrote down this idea in a much-noticed dossier.
Fuest believes such a scenario is unthinkable because it would be “akin to national bankruptcy”. The economist, on the other hand, believes that a weaker form of “financial repression” is very possible, even “very likely”. Financial repression means, for example, “that central banks lower interest rates despite high inflation or do not raise them far enough to achieve their inflation target, or that banks and insurance companies are required by regulation to hold more government bonds.”
A dangerous mixture is brewing
For the time being, the trend towards higher capital market interest rates is intact. Rogoff believes that the yield on ten-year US government bonds could rise by another percentage point in the foreseeable future. Ultimately, the rising interest rates are also a symptom of a growing distrust of attempts by states to secure the financing of their hunger for debt. This creates a disastrous cycle: high levels of debt lead to a loss of investor confidence, which in turn drives up the debt through higher risk premiums.
Another important driver of capital market interest rates is ongoing inflationary pressure: “The energy price shock leads to higher inflation, and that in turn increases bond yields,” said Rogoff’s Harvard colleague Ludwig Straub at the German summit of Handelsblatt and “Wirtschaftswoche”. And there is no end in sight to the shortage of oil and gas due to the ongoing war in Iran.
Meanwhile, Tehran is not only blackmailing the world with the extensive blockage of the Strait of Hormuz. Through their Houthis allies in Yemen, the mullahs also control the second important shipping lane through which the global economy supplies itself with oil: the Bab al-Mandab Strait, i.e. access to the Suez Canal. The consequences for world energy prices and thus inflation simply cannot be calculated. The price of crude oil has just risen above the critical $100 mark again. And overall, rising prices tend to mean rising long-term interest rates.
There are other reasons for the new world of interest rates: The fact that government borrowers are under increasing competitive pressure from AI giants is also putting a strain on the global bond markets. Today, the big Silicon Valley companies no longer buy government securities to invest their billions in profits. They take on debt themselves to finance their major investments in data centers.
Financial market players are running out of safe havens
So what can governments do to break the disastrous debt-interest-debt cycle? Budget consolidation would be unavoidable for investor confidence. However, many governments avoid this - not least in order to slow down the rise of the political fringes on the right and left through social policies that are difficult to finance.
Capital market players, in turn, are running out of safe havens. Lars Feld, director of the Freiburg Walter Eucken Institute, currently sees German government bonds in this role. In fact, Europe's largest economy, with a triple-A rating and a debt ratio of a good 60 percent, is one of the more solid countries - still.
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USAFranceEuropeFedGermanyDonald Trump
This is what it looks like, the new world of interest rates - and no matter how clever the government's tricks are, the economic laws cannot be overridden. Or as the economist Milton Friedman once put it: There is no such thing as a “free lunch.”
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