Bond markets and public finances are at odds

According to Terry Tanaka, an obsession with short-term fiscal prudence is likely to lead to even bigger risks in a few years

Investors in bonds and stocks are fundamentally at odds. Anything that jeopardizes the bondholder's interest and capital is detrimental. The perfect borrower might be someone who takes your money, puts it in extremely secure assets to safeguard the principal, and prioritizes paying the coupons over all other cash flow needs. If the borrower takes a chance, there is no benefit. Long-term survival actually has little value because the bondholder is still satisfied if they have received full repayment, and the borrower may fail owing to a lack of investment.

Conversely, equity, which Russell Napier refers to as "the fine sliver of hope between assets and liabilities," seeks to profit from increases in assets or earnings. Because they stand to gain if the risk is successful, shareholders want the company to take some sort of risk. It's okay if that raises the likelihood that loans won't be repaid.

Markets understand this very well. No one anticipates that shareholders and bondholders will act in each other's best interests. However, when it comes to public finances, that is entirely forgotten.

It's all about the connections.

We constantly hear arguments today about why the chancellor should either increase taxes or reduce spending. When we examine this from the perspective of the bond-equity framework, we can see that the goal is to increase bondholders' sense of security. The question of whether borrowing is increasing due to long-term investment or current spending is rarely discussed.

Bond investors could make a very beneficial intervention by indicating that borrowing to finance wasteful current spending would be viewed very differently from borrowing to invest in the infrastructure that Britain needs (with a well-costed plan). However, the majority of talking points essentially state that "large deficit = bad."

UK government bonds for ten years.

This logic is stretched into a strange kind of pretzel logic. We are informed with approval that tax increases will slow growth because they will reduce disposable income. Bonds would benefit from this since it might reduce inflation and enable interest rates to be lowered. However, it is frankly insane to think that anyone else would want slower growth in an economy that is obviously not overheating.

In this case, everyone who gains from increased investment and a stronger economy is an equity holder. And this is where the current mindset's long-term effects appear to be extremely concerning. Think about how Britain's social and physical infrastructure is clearly deteriorating. If this is not resolved because the government is intimidated by the self-serving bond vigilantes, populist parties will have more opportunities.

UK 10-year gilts currently yield 4.4%. This is not high by historical standards; the 15-year ultra-low rate policy is the only reason it feels high. It is true that it is high enough that growing interest rates further strain public coffers, making the problem even more difficult. However, it offers very little in the way of compensation for, say, the inflationary risk of a future government in five years with a populist mandate to spend and a willingness to be radical.