Investors warn of ‘new era of fiscal dominance’ in global markets

Investors have warned that big economies are entering a new period of “fiscal dominance”, in which central banks are under growing pressure to keep interest rates artificially low to offset the cost of record government borrowing.

The most prominent case is the US, where President Donald Trump has urged the Federal Reserve to slash rates to save billions of dollars in debt-servicing charges.

But government debt loads and rising borrowing costs in countries such as the UK and Japan are also putting central banks under pressure to ease monetary policy, economists and investors say, through other means such as slowing plans to reduce the size of their balance sheets.

The combination of government debt and increased costs was “creating enormous political incentives for governments around the world to put pressure on central banks to lower rates”, said Kenneth Rogoff, a professor at Harvard and former chief economist of the IMF.

While the US stands out for the explicit confrontation between the administration and the Fed, the global surge in long-term borrowing costs fuelled by government spending has put other central banks under market pressure to adjust policy to contain rising yields.

“We have entered a new era of fiscal dominance,” Rogoff added.

In the US, analysts say the current disparity between short-term rates — which are largely shaped by central bank policy — and more market-driven long-term borrowing costs partly reflects concerns that monetary policy will be kept looser than would be necessary to contain consumer prices.

The gap between two-year and 30-year Treasury yields is about its widest since early 2022, as short-term yields fall in the expectation of rate cuts.

In the UK, long-term borrowing costs are particularly high, with the yield on 30-year gilts at 5.6 per cent, close to its highest level in more than a quarter of a century, compared with about 4.9 per cent for 30-year Treasuries.

Analysts at Capital Economics highlighted the aftermath of last week’s US inflation numbers, following which Trump renewed his attack on Fed chair Jay Powell. While two-year US Treasury yields fell 0.02 percentage points on the day, as investors cemented their bets on rate cuts, 30-year yields rose 0.04 percentage points.

“That is an unusual response to a relatively uneventful data release,” the Capital Economics analysts noted, saying it hinted “at what would happen if Powell were actually removed or . . . the White House took other steps to exert more control of monetary policy, in particular nominating a new Fed chair seen as a stooge for the president”.

The temporary appointment to the Fed board of governors of Stephen Miran, a White House insider expected to push for rate cuts, shows that “the risk of US fiscal dominance is growing”, said Trevor Greetham, head of multi-asset investing at Royal London Asset Management. 

Thierry Wizman, global rates strategist at Macquarie Group, said there were signs of a “fiscal capture trade”, pointing to futures markets that are pricing in five quarter-point rate cuts by the end of next year — even though big Wall Street banks have improved their economic forecasts in recent months.

“[Five cuts] seems excessive if you are not pricing in a recession,” Wizman said. “It must be because some people think we are going to have a structurally dovish Fed chair and a structurally dovish FOMC,” he added, in reference to the Federal Open Market Committee, which sets interest rates.

Many other countries share many of the US’s debt dynamics — even if the rhetoric elsewhere is less highly charged.

The OECD says it expects sovereign borrowing among the high-income group of countries to reach a record of $17tn this year, compared with $16tn in 2024 and $14tn in 2023.

Developed-market central banks are still bringing their monetary policies and balance sheets back to a more “normal” setting, after years of quantitative easing — the massive bond purchases intended to help their economies recover from the financial crisis and the Covid pandemic.

But efforts to shrink balance sheets by selling back such bonds can also push up yields and add to government debt servicing costs.

Investors are watching the Bank of England closely to see whether it significantly scales back its bond sales programme — so-called quantitative tightening — at a decision scheduled for next month.

“The dilemma they have is, if financial conditions tighten because of the government’s moves on fiscal policy, the bank cannot be seen to be accommodating that fiscal policy,” said Mahmood Pradhan, global head of macroeconomics at Amundi Asset Management, referring to the Labour government’s debt and spending plans. “I think the bank will resist pressures of fiscal dominance very strongly.”

But even in Germany, long known for its balanced budgets, 30-year borrowing costs have risen to more than 3 per cent — their highest since 2011 — largely because of the new Berlin government’s plans to increase borrowing to revive the country’s infrastructure and boost defence spending.

Some economists worry that such trends will encourage governments to switch from long-term to short-term debt — making countries more exposed to interest rate gyrations.

“The volatility makes it harder to own the long end, and therefore harder to issue there,” said Matthew Morgan, head of fixed income at Jupiter Asset Management.

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The countries with the biggest debt as a share of GDP may be the most exposed. Veteran macro investor Ray Dalio has warned of a “debt death spiral” in an extreme scenario where governments are forced to borrow more to service surging interest costs.

If bond yields “get too high, central banks will need to step in again, print money and buy [bonds] to try to hold rates down, which will reduce the value of money”, he said in an interview.

Dalio added that such concerns could reduce the value of “major reserve currencies” — such as the dollar and the euro — against gold, which has hit a record high this year.