Discipline isn’t enough: why bond markets reward credibility, not austerity

On 5 October 2026, the US 10-year Treasury yield hit 5.31%, its highest level since 2002, reflecting the conspicuous effects of a $40 trillion national debt, amplified by inflationary pressures from the war with Iran. This bond market frenzy is not confined to the US. The UK's 10-year gilt yield rose to 5.44% in late September, Japan's 10-year yield climbed above 3% for the first time since the 1990s, and France's spread over Germany stood at 148bp in early November, wider than Italy's, despite Italy's well-known chronic debt woes. Italy's debt still sits well above France's, at 137.9% of GDP compared with 118.5%, which raises the question: why do markets punish some indebted governments more than others, regardless of their debt-to-GDP ratios? The answer lies in the path and credibility of a country's fiscal plan, not in its level of debt.

Global public debt was just under 94% of GDP in 2025 and is projected to reach 100% by 2029. Every G7 economy carries a significant debt burden; however, the picture changes when you examine the momentum of debt, past and projected, across countries. Chart 1 reveals exactly this: debt in the US and France is projected to rise until 2031, whereas Italy and the UK show falling and plateauing trends (IMF data, October 2026). Projected 2026 fiscal deficits provide context for these trends: the US at 8.5% of GDP, France 5.4%, Germany 4.3%, the UK 3.8% and Italy 2.9%, reflecting high spending relative to tax revenue in the US and France. Italy's primary balance for 2026 is projected at +1.0%, a surplus, compared with France's −2.9% and the US's −4.9%. The Italy-France puzzle exposes the market's priorities: Italy's higher debt is seemingly overlooked, while its primary surplus is viewed as healthier and more credible, earning it a tighter spread. Debt levels alone do not decide a country's fate. Between April and October, the IMF raised its 2031 debt forecasts for the US (from 142% to 145% of GDP) and France (from 121% to 124%) and cut them for the UK and Japan, a sign that markets are reacting to where debt is heading, not where it stands today.

The r-g differential, or the snowball effect, is a key tool for evaluating sovereign debt sustainability. It measures the gap between the effective interest rate on government debt (r) and the economy's nominal growth rate (g). When r<g, the snowball shrinks debt by itself; when r>g, debt grows by itself, even with a balanced budget. The annual change in the debt ratio equals debt multiplied by (r-g), divided by (1+g), minus the primary balance. It follows that interest makes debt grow, growth shrinks the ratio, and the primary balance (the budget balance before interest payments) adds or subtracts. A worked example for France is given below. The debt-stabilising primary balance is the surplus that exactly offsets the snowball: France needs +1.8% of GDP, yet it runs −2.9%. The difference, 4.7 points of GDP, is France's credibility gap: the budget adjustment it needs simply to stand still.

The snowball effect is something of a ticking time bomb for the G7. Governments pay interest on debt issued over many years, much of it at the low rates of the 2010s, so the effective rate they pay today is well below the market rate on new debt. Every year, a slice of old, cheap debt matures and is refinanced at today's yields, and the effective rate creeps up. As the table shows, the snowball flips from helping to hurting in every country except Germany. Hence, debt that looks stable today can still be on an unsustainable trajectory. Japan is the extreme case: growth currently shrinks its debt ratio by over 5 points a year, an advantage that almost disappears once its debt reprices at 3%. Maturity determines how fast the bomb goes off. With an average maturity of 14 years, roughly 7% of UK debt is refinanced each year; the US, at around 6 years, refinances roughly 17%. The same yield shock therefore hits the US budget more than twice as fast. Disinflation is also a double-edged sword: although it lowers yields, it lowers g as well. Consequently, any de-escalation of the Iran conflict that brings cheaper oil barely improves the US debt path unless the savings are banked.

The most recent instance of credibility lost overnight is the UK's 2022 mini-budget. £45bn of unfunded tax cuts, announced without an OBR forecast, sent 30-year gilt yields up by about 1.5 percentage points in a matter of days. The Bank of England was forced into emergency bond buying, and Prime Minister Liz Truss was out of office within weeks. The other end of the spectrum is Greece's fiscal tightening from 2010 to 2015, with deep spending cuts imposed during a slump. GDP fell by about a quarter from its pre-crisis peak, and debt-to-GDP rose from about 127% to roughly 180%. Returning to our debt arithmetic, Greece cut its primary deficit while g collapsed, causing d(r-g) to surge and its debt ratio to explode. These well-known debacles show that markets punish both recklessness and badly timed austerity. A political, rather than economic, example of lost credibility is France, where governments have fallen over budgets twice since late 2024, highlighting the market's harsh treatment of political failure. It is therefore apparent that markets are seeking a believable, credible path. But what does this look like?

Credibility stems from rules that are binding and that politicians neither break nor bend. However, the purest examples of fiscal credibility are small, rich and often lucky economies. Norway's sovereign wealth fund, the Oil Fund, is worth $2.3tn, with investments spanning equities, fixed income, real estate and renewable infrastructure. This wealth is guarded so carefully that government spending is capped at the fund's expected 3% real return, with the 2027 budget drawing just 2.7%. Singapore ran a FY2025 surplus of 1.9% of GDP. Its gross debt of 172% of GDP reflects borrowing to invest, with proceeds managed by its state-owned investment giant GIC, rather than borrowing to spend: further proof that debt levels alone tell you little. Norway and Singapore are the gold standard of sovereign fiscal credibility; however, large economies are fiscally more complicated, owing to greater bureaucratic inertia, diverse regional interests, sprawling infrastructure needs and the challenge of serving vast populations.

Ordinary economies with hard rules, such as Switzerland, may offer a more replicable model. Under its debt brake, approved in 2001, Switzerland caps ordinary federal spending at estimated structural revenues, and net federal debt sits at a mere 16% of GDP. Even in 2025, when the rule permitted a cyclical deficit, the government still ran a surplus. Sweden's fiscal framework was built after its 1990s debt crisis, when the Swedish-German 10-year spread blew out to over 4 points. Expenditure ceilings, a surplus target and balanced-budget rules for local government were introduced in the years that followed and adhered to, stabilising public finances. Interestingly, surpluses explain less than a fifth of Sweden's subsequent fall in debt. The rules worked indirectly: politicians committed to sound finances and refrained from spending the gains as debt fell, an example of rules working through credibility rather than arithmetic. Two economies serve as warnings. Ireland would have run deficits of €7.4bn in 2025 and €14.3bn in 2026 without its windfall corporation tax. Discipline with windfalls is not the same as a sound underlying budget: markets do credit Ireland for saving, but its credibility rests on revenue it cannot control, rendering its path less sustainable. Since 2001, Chile has used a structural balance rule that sets spending based on long-run copper prices, so that booms are saved and busts are cushioned. However, Chile has run deficits in 12 of the past 14 years, debt has risen to 45% of GDP, and the finance ministry has dropped its target of reaching structural balance by 2030. Chile is the counterweight to Norway: both manage a commodity windfall through a rule, but they differ in their political commitment to it, with Chile repeatedly missing its targets. Ireland and Chile both show that credibility comes from durable behaviour, not from good rule design on paper.

So what can large economies do to solve their debt problems? The answer lies in five vital levers: a believable anchor, an independent referee, consolidation that does not kill growth, growth itself, and political buy-in. Canada is a G7 economy that pulled it off. Federal debt peaked at around 70% of GDP in the mid-1990s; the landmark 1995 budget led to a surplus in 1997-98, and debt fell for a decade afterwards, helped by r<g.

Canada had a believable anchor, albeit only partly. There was no law or formal rule governing the budget or spending; however, its finance minister, Paul Martin, set short, rolling deficit targets and promised to hit them 'come hell or high water'. His commitment became believable because he kept beating those targets: every single year, nine budgets in a row, by a cumulative total of about C$79bn. Switzerland's debt brake, written into the constitution and consistently respected, offers an even clearer anchor.

The importance of an independent fiscal referee is clear. Much like the case for central bank independence, fiscal planning and forecasting are vulnerable to bias and over-optimism when left solely to politicians. The UK's Office for Budget Responsibility (OBR), established in 2010, brought stability to fiscal forecasting throughout that decade, and the mini-budget's decision to bypass an OBR forecast underlines the value of fiscal referees. They guard against fiscal recklessness and mitigate sovereign risk.

Consolidation that does not hurt growth comes in two forms: front-loaded, fast cuts, and gradual consolidation. Canada's 1995 cuts were fast, deep and mostly to spending, similar to Sweden's cuts in the 1990s. What both had in common was something offsetting the drag on growth from these cuts: chiefly cheap currencies, export demand and falling interest rates. Greece, by contrast, cut fast with none of these cushions, resulting in economic collapse and rising debt. On the gradual side, Belgium's debt fell from 138% of GDP in 1993 to 87% in 2007. This was not owed to shock therapy, but to a large primary surplus, averaging 4.7% of GDP a year, sustained over a long period. It also coincided with steady growth, averaging 2.4% a year. A common theme emerges: the importance of growth, the most crucial lever of all.

Canadian growth swung from a 2.1% contraction in 1991 to 5.1% growth in 2000, supported by a booming US economy next door, a weak Canadian dollar and falling interest rates. In 1995, Canadian rates rose sharply across all maturities in the wake of the Mexican peso crisis, with short-term rates averaging 7.1% and the 10-year yield 8.2%. Investors were nervous about Canadian government bonds and demanded a risk premium. Then, from mid-1996 to 2000, Canadian interest rates were mostly lower than comparable US rates: the risk premium had vanished, fuelling growth. From there, r<g steadily eroded Canadian debt, completing the turnaround story.

There was also broad political buy-in in Canada. Public opinion had turned after rating downgrades and headlines mocking the Canadian dollar as the 'northern peso'. The main opposition party wanted even deeper cuts, and the provinces tightened their own budgets too, demonstrating national support for the government's push for budgetary strength.

There are other G7 success stories, such as the US in the 1990s, which achieved surpluses by the end of the decade through tax rises, spending restraint, a productivity boom and a post-Cold War peace dividend. As mentioned before, the most formidable of these levers appears to be growth, which directly drives the snowball effect. Below is a snapshot from a debt stress-test simulator built on IMF projections to 2031 and the debt equation set out earlier. For the UK, 1 point less nominal growth adds about 5 points to debt by 2031, whereas a 150bp yield shock adds about 1.5 points, and 1 point less fiscal effort adds about 4. It follows that growth matters more than both yields and fiscal tightening when it comes to the path of debt.

Calls

US 2s30s steepener

Despite France's political and economic instability, the US appears to be the large economy most exposed on credibility. After the Democrats won the House and the Senate in the midterms, two forces are now pulling on Treasuries in opposite directions. At the short end, there is cyclical relief: Brent fell about 8% in the week to 3 November, to around $104, on reports of a draft deal to end the Iran war. Cheaper, more abundant oil means lower inflation, room for Fed cuts and lower 2-year yields, and Treasuries rallied on the result. At the long end, however, there is no structural fix: divided government means no new tax rises without a presidential signature, and no new unfunded tax cuts without Democratic votes. This gridlock stops the gap getting worse but does not close it. Neither party has made deficit reduction a priority, and the IMF projects a deficit of about 8% of GDP every year to 2031. As the simulator results below show, cheaper borrowing barely bends the debt path, because disinflation also slows nominal growth. Debt only turns down if the savings are banked, which makes the case for a 2s30s steepener.

The data below, from the New York Fed's ACM model, break down the move in 2-year and 10-year Treasury yields from the 7 October peak to today. Almost all of the fall in yields came from term premiums shrinking as war and inflation fears eased. Expected Fed rates barely moved, and at the 2-year horizon they actually edged up. Additionally, the market is not pricing cuts: the expected Fed rate over two years sits at 4.35%, above today's fed funds rate of 3.88%. Finally, the fiscal premium is still present: at 0.71%, the 10-year term premium is near the top of its range since 2015 and has drifted higher over the past two years as debt projections have risen.

The table below shows market levels as of 6 November 2026. At the long end, the CBO estimates that each 1 point of debt-to-GDP adds 2-3bp to long-term rates over time. US debt rising by about 18 points (from 127% to 145%) therefore implies 35-55bp of extra yield, but spread over five years, so only 7-11bp a year, reflecting long-term debt concerns. The 2-year proves to be the main driver over the next year: sitting about 60bp above fed funds, it already prices little easing. If cheaper oil lets the Fed cut by a further 50-75bp, the 2-year yield could fall 40-60bp while the 30-year is held up by the fiscal premium. Over 12 months, the steepening would come mostly from the front end falling, with the fiscal story stopping the long end from following it down.

France–Italy spread

The OAT-Bund spread was about 148bp on5 November, wider than the BTP-Bund spread, which was roughly 105-115bp in early November. Italy runs a primary surplus of about 1% of GDP, while France needs about 4.7 points of adjustment, and the IMF projects French debt to keep rising to about 124% of GDP by 2031. The April 2027 French presidential election keeps a political risk premium embedded in OATs.

As shown in the graph below, France has rarely traded above Italy: on monthly averages, it has done so in only four months since 2005, and by no more than 5bp. On 26 October, the gap was +45bp, a striking reversal for a country that, from 2009 to 2023, borrowed up to 3.7 points more cheaply than Italy. Stripping out the risk common to the euro area's weaker borrowers leaves a France-specific premium of about 1.2 points, roughly 7 standard deviations above normal and far beyond anything seen in the 2011-12 euro crisis. Fundamentals justify much of this: France runs a primary deficit while Italy runs a surplus, French debt is still rising while Italy's edges down, and France's credibility gap is three times Italy's. Together with repeated government collapses, that divergence explains the steady climb in the OAT-BTP spread from −87bp in March 2024 to +45bp today. The premium is also persistent, halving only every 15-18 months, so even if Italy's spread held steady, France would still trade around 20bp above Italy by the April 2027 election.

We can also assess the effect of past political shocks. The June 2024 dissolution of the French National Assembly added 14bp to the OAT-BTP spread, Barnier's fall in December 2024 added 12bp, and Bayrou's fall in September 2025 added 13bp. Each crisis added to the spread in a way that never fully reversed. Looking further back, before the 2017 election the OAT-Bund spread widened by about 50bp, then fell about 35bp within three months of Macron's victory, suggesting that election premiums build into the vote and can collapse quickly after a market-friendly result. This suggests the OAT is likely to keep trading above the BTP going into the election.