Why soaring interest rates are striking fear into Europe and the US

Andreas Cervenka

This is commentary piece.The analysis and views expressed are the author’s own.

Published 06:38 | Updated 08:17 

For decades, politicians on both sides of the Atlantic have been able to put off difficult decisions and amass huge mountains of debt without facing major consequences.

Now, reality is knocking at the door.

No one misses a stock market crash.

Every percentage-point move up or down makes headlines in news broadcasts around the world.

What is happening in the global bond market is not as visible, even though it is worth as much as all the world’s stock markets combined—and the drama involved can be just as intense.

What is traded in the bond market are bonds—essentially IOUs.

When interest rates rise, the value of these securities falls—a concept that can seem somewhat counterintuitive.

Recently, interest rates have risen so rapidly that one could speak of a sort of mini-crash. Values ​​amounting to thousands of billions of kronor have gone up in smoke.

This week, the yield on a ten-year US government bond hit 5.34 percent—the highest level since 2002. France, the UK, and Japan also saw interest rates reach levels not seen in 20 or 30 years.

The rise in interest rates following the summer began as a response to climbing inflation, which in turn stems from the war in Ukraine and rising oil prices. When inflation rises, the value of money decreases; consequently, investors simply demand higher compensation—in the form of higher interest rates—for lending.

However, there has also been increasing focus on the massive sovereign debt levels in many countries—not least in the US, where the debt recently surpassed the $40 trillion milestone.

Another factor driving up interest rates is the staggering amount of borrowing taking place to finance the expansion of AI. According to an analysis by Morgan Stanley, $570 billion worth of AI-related bonds will be issued in 2026—an amount equal to the combined net borrowing of all eurozone countries.

As competition for lenders intensifies, investors can demand better terms, causing interest rates to rise.

In the past week, another factor has crept in: panic.

Reports indicate that falling values ​​of US government bonds have forced some investors to sell; this pushes down prices and drives up yields, triggering further sales in a vicious cycle.

In Europe, anxiety has mounted regarding France in particular. The country has not posted a budget surplus since 1974, and its debt-to-GDP ratio has continued to climb, reaching nearly 120 percent—matching that of the US. This represents a doubling since 2007 alone.

This situation was manageable when interest rates were extremely low in the years following the global financial crisis. However, this year alone, France’s government borrowing rate has risen from 3.5 percent to 5 percent. In Europe, confidence in a country is typically measured by the interest rate premium it pays over Germany, the continent’s largest economy. That spread has now reached 1.4 percentage points—the widest margin since the 2012 eurozone crisis.

Back then, it was Italy, Spain, and Greece that shook the entire eurozone. Now, France—Europe’s second-largest economy—is paying higher interest rates than those countries, fueling concerns about a new and potentially worse version of the eurozone crisis.

"Reality has caught up with us," declared French Prime Minister Sébastien Lecornu while presenting the budget this week. It includes savings amounting to nearly 600 billion kronor, achieved through a combination of spending cuts and tax hikes.

However, the measures are expected to reduce the budget deficit only marginally, leaving it at a still-substantial 5 percent of GDP. With an aging population, the outlook for the country’s public finances is bleak; by 2030, the cost of servicing France’s national debt is projected to exceed its defense spending by 60 percent.

It is not even certain that the budget will pass. France is becoming increasingly politically polarized, and the frontrunners for next year’s presidential election are currently two populists: Marine Le Pen on the right and Jean-Luc Mélenchon on the left.

Neither has presented credible plans to improve the state’s finances.

The 2012 Eurozone crisise was resolved when the European Central Bank (ECB) stepped in to buy bonds from Italy and Spain. No such bailout is expected for France—at least not for the time being. The country’s problems do not stem from an acute crisis but have built up over time.

The same applies to the United States, where the political debate over the national debt has reignited.

Republican Congressman Jodey Arrington, Chairman of the House Budget Committee, did not mince words when describing the situation recently:

"Our national debt continues to pose an existential threat to our nation’s future. We are mortgaging our children’s entire future to pay for today’s expenses—promises we have made but are unwilling to pay for ourselves."

He wants US states to force through a constitutional amendment requiring the federal budget to balance over time.

Significantly, he is preparing to leave office; it is only then that American politicians seem able to speak plainly.

It remains to be seen how the issue of the national debt will be handled after the upcoming midterm elections.

However, rising interest rates are not necessarily a bad thing. For one, they can signal that economic growth is picking up. Growth is the best way for a country to manage heavy debt.

Higher interest rates also mean there are alternatives to the stock market for those seeking a return on their money. This reduces the risk of bubbles.

Above all, the jitters over interest rates mean that alarm bells are ringing for politicians in several of the world’s most powerful capitals.

During the years when borrowing was virtually free, many countries could mask their problems by constantly reaching for their grandchildren’s credit cards.

That is no longer sustainable.