Borrowing Isn’t the Bond Market’s Only Concern—Growth Is Too

Here’s a surprise about the countries at the center of the bond-market selloff: They’re all borrowing far less than Uncle Sam.

This year, the International Monetary Fund expects Japan to have the smallest budget deficit in the Group of Seven advanced economies for the third year running, at around 2% of gross domestic product.

Excluding interest payments, Italy is headed for a small surplus. The U.K. and France are borrowing more, but the U.S. is in a league of its own, with a budget deficit forecast by the IMF to reach 7.5% of GDP this year and stay there through 2030.

Yet the bond market isn’t rewarding what would typically look like fiscal prudence. Yields are rising across advanced economies, as investors wrestle with resurgent inflation, the possibilities of artificial intelligence, and the debt loads and evolving spending plans of governments facing geopolitical upheaval.

Growth is one key distinction, however. The U.S. is forecast to grow faster than other major economies in the years ahead, propelled by the AI boom emanating from Silicon Valley and robust consumer spending.

Europe, the U.K. and Japan look stuck in a lower gear, with forecasts suggesting they’ll all struggle to eke out growth of as little as 1% this year and next, less than half the rate anticipated for the U.S.

Governments are pledging fiscal restraint, but with growth subdued some investors are skeptical they will be able to finance outlays on pensions and new priorities such as defense without more borrowing. For others, rising yields reflect optimism that AI might, in fact, give economies new pep.

Either way, over the long term, economies in Europe and Asia are facing more severe demographic pressures than the U.S. as their workforces age and shrink, further pinching their capacity for growth without some technology-fueled productivity boost.

That raises questions about how their economies will in future generate the income needed to repay hefty debts accumulated over time.

“It comes back to fiscal sustainability,” said Mansoor Mohi-uddin, chief macro strategist at the Bank of Singapore, a private bank. “That’s a function not just of growth but a willingness to make hard political choices.”

Bond yields have been creeping up all year as investors digest incoming news about inflation and growth.

The U.S. conflict with Iran has throttled tanker traffic through the Strait of Hormuz, a key conduit for Middle East oil to reach global markets, pushing up prices for oil and gas.

Yields, which move inversely to bond prices, took another lurch higher Tuesday just as finance ministers and central bankers from the world’s 20 leading economies were concluding two days of meetings in the U.S.

Many analysts said the spark was renewed hostilities between Washington and Tehran, reinforcing those inflation fears and the related worry that central banks will need to raise interest rates much more aggressively to keep price growth on target.

The bond selloff extended into Wednesday, pushing yields on Japan’s 10-year bond above 3%, a 30-year high, and the U.S. 10-year note to 4.8%. Benchmark 10-year yields also rose for the U.K., France, Germany, Italy, Australia and Canada. Higher bond yields push up borrowing costs for governments, households and businesses, hitting economic growth.

Some advanced economies’ growth prospects look subdued anyway, amplifying investor unease about lending to governments when inflation is quickening. Many are carrying debts that piled up during crises including the pandemic, and most are making new spending commitments rather than tightening their belts.

Consider Japan. Though it has a small deficit now, Prime Minister Sanae Takaichi has pledged more borrowing and spending to finance investment in boosting Japanese industries and a temporary sales-tax cut for consumers. The Japanese economy is forecast by the International Monetary Fund to expand just 0.6% this year, compared with 2.3% for the U.S. Overall public debt is the equivalent of around 200% of GDP, the highest among major economies after decades of deficit spending to combat deflation.

Japan’s population is forecast to shrink about 30% over the next 50 years, according to United Nations projections, leaving a dwindling workforce to service payments on past borrowing. Yields on Japan’s 30-year bonds Wednesday rose close to a record high of 4.2% reached in May.

The size of Japan’s debt is what concerns investors, said Eiji Ueda, partner and head of Asia-Pacific at Apollo Global Management in Tokyo. “Japan has been low-growth and issuing debt for a very, very long time,” he said.

Japan, though, has a bundle of foreign assets acquired over decades of overseas investment that it could call on to finance future spending and pay down debt. Most of that debt is anyway owned by Japanese retirement funds, insurers and other domestic investors. Japan is shrugging off years of deflation, which to some investors suggests yields should be higher.

Indeed, part of Treasury Secretary Scott Bessent’s anxiety about Japanese bond yields and weak currency is the risk that better returns could entice Japanese investors to dump U.S. assets and repatriate their funds.

European governments have struggled to cut welfare bills under pressure from upstart populist parties. Fear of Russia—and of abandonment by the U.S.—has prodded governments in Germany, France and elsewhere to earmark more spending for defense, which could bump up growth but also pushes up borrowing. The continent’s growth prospects trail the U.S., with Germany forecast to grow this year at just 0.7%, according to the IMF.

“A combination of potential inflationary pressures, prospects of rising debt levels in advanced economies, and structural factors such as worsening demographics all seem to have coalesced into a perfect storm,” said Eswar Prasad, professor of trade policy at Cornell University and a former senior IMF official.