Markets are losing patience with increasingly unstable global governments

For much of the last decade, financial markets were willing to grant governments the benefit of the doubt. Spiraling deficits, rising entitlement costs and geopolitical shocks were absorbed with relative calm, as interest rates hovered near zero and central banks stood ready with the safety net of large-scale asset purchases. It was a period in which public debt was largely treated as benign — if not invisible. 

That era is over.

Long-term yields are rising sharply across advanced economies. In the U.S., Germany and Japan, 30-year bond rates have climbed to their highest levels in years.

On the surface, this might seem like a mechanical reaction to changing monetary policy. But beneath, something deeper is stirring. The bond market is beginning to doubt the underlying political capacity to manage debt, and finding it wanting.

As the post-pandemic world settles into a more fractured and inflation-prone equilibrium, governments are being forced to confront the realities of high spending, rising interest burdens and slowing structural growth. 

In broad terms, there are three possible responses to this dilemma, each with distinct risks and consequences.

The first path is to rely, either deliberately or by inertia, on inflation as a mechanism of debt relief. By allowing inflation to run higher than interest rates, governments can reduce the real burden of their liabilities without having to raise taxes or cut spending, at least in the short term. 

This strategy, which economists refer to as "financial repression," helped lower debt ratios in the decades after World War II.

But in the current global economy, such a path is fraught with danger. Inflation erodes savings, disrupts investment planning and, above all, undermines public trust in both currencies and institutions. 

Once markets begin to suspect that inflation is being tolerated rather than contained, the result is not relief, but repricing. Yields rise. Currencies weaken. Capital takes flight. And the short-term fix gives way to long-term instability. 

Inflation, once out of the bottle, rarely plays nice. At best, if offers a temporary sleight of hand — at worst, a destructive spiral.

The second path is the route of forced consolidation under duress, a scenario that typically unfolds when policymakers hesitate too long and investor confidence collapses and markets crack the whip. We have seen this movie before. 

The United Kingdom’s 2022 gilt meltdown under Liz Truss offered a modern masterclass: Markets can humble even developed economies within days. History, from Greece to Argentina, is littered with examples of fiscal drift addressed too late. In such episodes, bond yields can spike dramatically and rapidly, triggering emergency austerity measures, political upheaval and severe social stress.

The third and most constructive path is one of proactive reform — a deliberate effort to restore credibility through pension and healthcare reforms, targeted expenditure control and structural improvements to the tax base. 

This is not an easy road. It involves political costs, institutional discipline and the willingness to make unpopular choices in the present for the sake of stability in the future. Yet, it remains the only path that preserves policy sovereignty and avoids the trauma of abrupt market intervention. A stitch in time that spares a reckoning.

Different economies are navigating these choices with varying degrees of clarity — or confusion.

In the U.S., the so-called “big, beautiful bill,” with its sweeping tax cuts and spending pledges, has added to the impression of fiscal drift. 

With the Federal Reserve under growing political pressure and a possible leadership change on the horizon, markets are understandably nervous. The term premium on long-dated Treasuries has widened, signaling that investors are demanding more compensation for what they see as mounting uncertainty, not just economic, but institutional.

Across the Atlantic, attention is shifting from the usual suspects. For years, Italy was viewed as Europe’s most precarious sovereign. But with relative political stability and a more transparent fiscal trajectory under Prime Minister Giorgia Meloni, Rome has begun to reassure markets, at least for now. 

France, in contrast, is raising eyebrows. Recent bond spreads suggest that investors are beginning to question Paris’s capacity to govern, let alone to reform. 

A fragmented parliament, a wobbly prime minister, a reviled president, persistent deficits and strong public resistance to structural adjustments, particularly pension reform, have all contributed to a growing sense that France could become the next flashpoint.

Japan, long considered a unique case due to the domestic ownership of its debt and the Bank of Japan’s formidable bond-buying power, is no longer immune to pressure. As inflation has begun to rise and the political landscape becomes more fragmented, long-term yields have started to climb. With more political instability looming, Japan’s markets seem to be bracing for turbulence.

Complicating this picture are several external forces that make the task of fiscal repair even more challenging. 

Geopolitical tensions from Eastern Europe to the Indo-Pacific are pushing defense budgets higher. The retreat from hyper-globalization is increasing the cost of doing business, while also fuelling strategic competition over critical technologies. 

And although technological change offers the promise of higher productivity and better revenue collection, it also brings disruption, inequality and transition costs that governments cannot ignore.

Taken together, these trends mean that fiscal prudence is harder, but also more necessary, than it has been in decades.

For now, markets remain in a state of guarded observation. Yields have risen, but there is no panic — yet. The calm is conditional, and the clock is ticking.

Each new budget, monetary policy decision or geopolitical flare-up has the potential to shift sentiment and shed more light on who will ultimately prevail: the reformer, money printing press or market scourge.

In the words of Augustin Carstens, general manager of the Bank for International Settlements: “Central banks cannot be the only game in town.”  

Indeed, the ball is in the policymakers’ court. If they act in time, markets will reward them with calmer waters. If not, then bond markets will remain a mirror in which investor concerns become increasingly visible.

Andy Langenkamp is senior strategic analyst at ECR Research and ICC Consultants.