In the October budget, Treasurer Jim Chalmers outlined the long term costs embedded in Australia’s fiscal outlook. Much of those costs were consequences of the Covid pandemic and the Government’s massive fiscal response (circa $300 billion). Significant further ongoing costs have emerged from the ageing demographic structure of our society, a forecast NDIS blowout, and Labor’s childcare initiatives – all adding to future fiscal deficits and government debt.
In particular, it is the forecast cost of servicing Government debt over the next decade that deserves our attention. Whilst Australian government debt is both significant and manageable, the Treasurer has given investors an important insight into the massive financing problem awaiting most developed world economies.
The outlook for future budget outcomes presented by Treasury in the following chart shows that Commonwealth payments (expenditure) will lift from 25% of GDP prior to Covid to 28% of GDP in ten years’ time. Meanwhile Government receipts will rise from 24% to 26% of GDP. The 2% gap between expenditure and receipts represents a projected deficit of approximately $70 billion per annum in 2032. Given there is no projected surplus at any point, the Commonwealth’s debt will grow over the same period by about $500 billion to 35% of GDP.
Commonwealth debt is essentially funded through the bond market, and the massive blow-out in debt from 2020 to 2022 was supported by the RBA’s equally massive Quantitative Easing program. During this QE program, the RBA acquired $224 billion of Commonwealth bonds and $57 billion of state government bonds in the secondary bond market. For a period, the RBA bought more bonds in the secondary market than were actually issued. This resulted in the RBA owning some 35% of all Commonwealth bonds on issue, similar to the ownership level that the US Fed has in its Treasuries market, but well below the estimated 50% of Japanese issued bonds owned by the Bank of Japan.
There are two important points to note from the above observations. First, the 35% ownership by the RBA is of a much smaller pool of net debt. Australian Commonwealth net debt is 30% of GDP, whilst the US Treasuries market is equivalent to 100% of GDP and in Japan 220% of GDP. Second, the resulting effect of rising bond yields on the fiscal outlook in Australia is small compared to the US. Indeed it explains why Japan has essentially frozen its bond yields even as inflation lifts.
Let’s be clear – this year’s rising bond yields are a significant long term concern for the financing of developed world governments and solutions will either need to be found or current policies recycled in more aggressive forms.
The following table shows the major economies that will be severely impacted by rising bond yields. The UK, Canada and the Eurozone join the US and Japan with disturbing fiscal funding predicaments.
How serious are rising bond yields for major western governments? We were given an insight by Treasury in the budget papers in the following chart.
By reverse engineering the forecasts, we can deduce that Australia’s gross debt will reach $1.5 trillion by 2032. Today our gross debt is about $1 trillion and the interest costs amount to just 0.8% of GDP (or about $16 billion). In 2032, the interest bill will be 1.8% of GDP (or about $50 billion). Interest will represent 8% of Commonwealth outlays as the average bond yield (across maturities) is anticipated to be about 3.5% (as opposed to just 1.6% in 2022).
The interest bill is low today because the RBA pushed bond yields down towards a zero yield in the secondary market of 2020/2021 as the Government issued bonds in the primary market. A focus of the RBA QE program was on 2024 maturing bonds: these bonds traded at negligible yields because the RBA told the market that cash rates would not rise from 0.1% for 3 years. The RBA Governor has now apologized for this, but the repercussions are serious – for both mortgage holders and bond investors.
The magnitude of the bond issuance (maturities around 2024) is seen in the next table. When these bonds mature at near zero yields, they will be rolled into new bonds that yield 3.5%. The resultant effect on the budget outcome is significant. Fortunately, it remains manageable because Australia’s government debt is relatively low and our economy will grow faster than our international peers. Debt can be both grown away or inflated away if interest rates are held below inflation.
The above gives investors an insight into what Governments and Central Banks are expected to do over the next decade. In Japan, interest rates adjustments (cash rates) cannot be undertaken because they will feed into long dated bond yields and destroy Japan’s fiscal management. If Japan were to pay 3.5% on its debt, that would consume 8% of GDP and 33% of its budget outlays. It would confront a tsunami of interest expenses.
Across the Eurozone (think Italy and Greece), the UK, Canada and the US, Government debt is so high that it is unlikely ever to be repaid. Indeed, the consequences of sharply higher bond yields at the end of this decade could be disastrous.
It seems clear that QE is here to stay as a fundamental component of monetary policy because it is necessary to fund western Governments. Whilst interest rates are on the rise, there is a fundamental fiscal point above which they cannot go. It is the level of Government debt that will determine where that point is for most countries, whilst in Australia it is the level of mortgage debt that will set our cap.
If inflation remains intransigent, expect negative real yields (rates below inflation) to become a semi-permanent feature of economic management. That’s a strange tailwind for risk assets (equities and property) but a headwind for bond markets.