G7 debt levels soar, and the market begins to get nervous!

On June 3rd, according to Reuters, the massive debt burden of G7 countries is becoming a new pressure point in the market. Although a debt crisis may not be the most fundamental scenario, the alarm bells have begun to ring.

The report states that soaring government debt levels are becoming a pressure point for G7 countries, with bond investors turning their attention to those countries that are not doing enough to improve their fiscal conditions. IMF data shows that over the next five years, the debt-to-GDP ratio of four economies in the G7 is expected to rise.

When Moody's stripped the U.S. of its "last AAA rating" in May, coupled with Japan's government bond auction facing the coldest reception in 16 years, global bond investors focused on the U.S. and Japanese government bond markets.

From a market performance perspective, concerns about the U.S. and Japanese government bond markets are at the forefront, while the government bond markets of other G7 countries, such as the UK and France, are also causing investor worries.

United States: From Safe Haven to Eye of the Storm

As early as April, following the so-called "reciprocal tariffs," the U.S. faced multiple hits in stocks, bonds, and currencies, with the severe sell-off in the U.S. bond market already ringing alarm bells. In addition to tariffs, Trump's "Big Beautiful" plan has exacerbated the debt issue:

According to estimates from the nonpartisan think tank Committee for a Responsible Federal Budget, the plan could increase debt by about $3.3 trillion by 2034.

Moody's downgrade decision in May dealt another blow to U.S. bonds, and JPMorgan CEO Jamie Dimon recently warned of "cracks" in the bond market, partly attributing it to excessive spending, stating that the U.S. government's previous "massive overspending" and the Federal Reserve's similarly "massive overspending" in quantitative easing have planted a time bomb for the bond market, which could lead to a "collapse" of the bond market.

Although the dollar's status as the global reserve currency provides some protection for the U.S., Treasury Secretary Scott Bessent also promised that the nation would never default, investors remain concerned that the yield on the 10-year Treasury bond may break through the critical level of 4.5%.

Additionally, the banking sector hopes that U.S. regulators may soon revise the supplementary leverage ratio, which would reduce the cash reserves banks must hold and encourage them to play a larger role in the government bond market.

Japan: The Textbook Debt Management Model is Failing

For years, Japan has been the textbook case of how the market can overlook a massive debt burden. Now, all of this is changing.

Japan's public debt exceeds twice its economic output, the highest among developed economies. In May, Japan's 20-year government bond auction recorded the worst results since 2012, raising doubts about market demand for Japanese government bonds, with long-term bond yields hitting historic highs. The cost of borrowing for 30-year bonds has surged by 60 basis points over the past three months, even exceeding that of the U.S The culprit is: as the Bank of Japan's bond holdings decline for the first time in 16 years, traditional buyers such as life insurance companies and pension funds are weakening their demand for long-term bonds. The Bank of Japan holds about half of the market share.

Although policymakers are considering cutting ultra-long-term bond issuance, temporarily alleviating market concerns. However, last week's poor Japanese government bond auction indicates that the problem may be more deep-rooted.

"Weak Japanese auctions are symptomatic of some deep-seated issues," said Jan von Gerich, Chief Market Strategist at Nordea.

UK: Vulnerability Under Fiscal Discipline

In Europe, the UK, with a debt-to-GDP ratio close to 100%, remains vulnerable to the impacts of a global bond sell-off, even while emphasizing fiscal discipline.

UK Chancellor Rachel Reeves will unveil a multi-year spending review report next week, which could pose another test for the country's 30-year government bonds.

Currently, the yield on UK 30-year government bonds exceeds 5%, making it the only G7 economy with such a yield.

Jane Foley, a strategist at Rabobank, noted that the UK government seems prepared to increase spending in areas such as defense and health, despite commitments not to raise taxes and to maintain spending cuts. The International Monetary Fund has urged Reeves to stick to plans to reduce public borrowing.

Sam Lynton-Brown, Global Macro Strategy Head at BNP Paribas, stated that an earlier end to active bond sales by the Bank of England could support the UK government bond market.

France: Political Risk Temporarily Eased

The pressure on the French bond market, driven last year by concerns that political instability would hinder tightening efforts, has eased. The risk premium investors demand for French debt relative to German debt has fallen from 90 basis points in November to about 66 basis points.

Additionally, driven by expectations that European countries will strengthen cohesion in areas such as defense, investors have bet on a decline in Eurozone risk premiums.

However, caution is still needed. French Prime Minister Francois Bayrou plans to announce a four-year deficit reduction roadmap in July, which could set the stage for parliamentary budget battles.

"Since the COVID-19 crisis, there has been no improvement in France's debt situation," said Eliezer Ben Zimra, fixed income fund manager at Carmignac.

Italy: An Unexpected Stable Winner

Due to enhanced political and economic stability and improved credibility, Italy's budget deficit is expected to decrease from 7.2% in 2023 to 3.4% in 2024, and further to 2.9% by 2026.

Kenneth Broux, Head of Corporate Research for Foreign Exchange and Rates at Société Générale, pointed out: "This was unheard of years ago." Broux stated that although Italy still faces challenging long-term debt dynamics, its relatively better performance compared to countries like France and diversification support for European assets have bolstered its bonds.

Currently, the yield spread between Italian and German 10-year bonds is close to its narrowest level since 2021, slightly below 100 basis points