Debt markets are reacting to economic risks

The latest economic releases in September and updated forecasts from major economic institutions suggest that the global economy remains fairly resilient despite the double shocks of the Trade War and the Iran-US war. Spearheaded by US economic growth (est 2.2% for 2026 average forecast), the wider economic outlook has in fact improved. Economists surveyed by Bloomberg now also think that European economies will fare better than previously thought: UK GDP growth for 2026 has risen from 1% to 1.2%, and European growth from 0.6% to 0.9%. Inflation expectations remain between 2.9% and 3.4% for this year across the board, but next year is expected to see more subdued prices.  

US corporate profits for Q2 surpassed projections (+27% year-on-year), and Q3 projections show similar numbers. When interviewed, C-suite executives revealed that the AI investment super-cycle is the dominant story. 70% of large companies have, reportedly, adopted AI. However, supply constraints are reportedly growing (labour, AI, geopolitics, infrastructure). Inflation pressures have risen, but pricing power has not kept pace, so companies are very conservative about hiring, especially in junior positions, to improve or maintain their margins. Meanwhile, tariff refunds have helped lift margins and offset rising costs. Companies report that consumption remains steady but not expanding, as the pace this level of economic growth would usually suggest.  

Inflation is likely to persist for the time being. The inflation backdrop is deteriorating in a non-linear way. As oil reserves are being depleted and refineries taken offline due to the double geopolitical threats in Ukraine and Iran, gasoline and diesel prices have been climbing. We would expect inflation to rise before it falls, possibly even beyond the expected at year’s end. Absent those threats, the world could see an oil supply glut, which could lead to a rapid de-escalation in prices.  

Consumption remains robust. Across the US, EU and the UK, we are seeing resilient consumers. However, retail sales numbers are only telling part of the story. As expenditure for energy needs increases, consumers across the board also reduce more discretionary items. This leads us to believe that the underbelly of the economy is softer than headline numbers might suggest.  

An oil supply problem spills over to refining. The persistent disruption in the oil supply market due to the half-year closure of the Strait of Hormuz and attacks on Gulf infrastructure has accentuated problems in refining, which became more evident in August. With refining capacity already constrained by 2020 refinery closures and Ukraine’s attacks on Russia’s refining facilities, refiners are becoming hard-pressed to deliver oil products (like gasoline, diesel, jet fuel, vessel bunkers, etc.) at low prices.  Refiners have been able to call on reserves for a while, but refiners are now operating at or beyond capacity, and reserves of things like gasoline are running low.  

A global debt market problem 

Against a backdrop of good US-led global economic growth, debt markets are showing signs of significant stress. Accelerating global debt interest payments and a series of events has now led to increased worries over the G7 governments' ability to repay their debts in real (non-inflationary) terms.  

The consequences of America’s geoeconomic and geopolitical shift, a global trade war and a military campaign against Iran have spilt over to global debt markets. Rising inflation expectations, mostly due to fuel shortages, are forcing central banks to reverse their previous course and raise interest rates instead of lowering them.  

Inflation is also hitting Japan, which is experiencing the highest interest rate since 1995, shifting some Japanese investor preferences away from US Treasuries and more into Japanese Government bonds. Since February, Japanese investors have reduced their US Treasury demand by 10%.  

Three further events catalysed increased volatility: 

• First, US Treasury Secretary Scott Bessent’s attempts to bring down long-term borrowing costs failed, highlighting the US government’s vulnerability. After initial euphoria, markets shrugged off the attempt to influence the bond market, with $6bn worth of buying on a $32tn market.  
• Second, on 23 September, the US Treasury sold $70bn of 5-year bonds at a high yield of 5.033% against an original issuance level of 5.002%, a 3.1 basis point (0.031%) difference. This is five times the six-auction average of 0.6 basis points, and it was reported as the second-largest difference (“tail”) on record for this particular bond. The bid-to-cover ratio was low, 2.21x offer against supply, versus a 2.33x average, the weakest since December 2018. US longer-term yields shot up, spilling over to the rest of the world.  
• Third, French PM Lecornu's 2027 budget contained €43bn of new savings and revenue measures, €54bn including earlier ones, to cut the deficit from 5.4% to 5.0% of GDP. Markets were, however, unconvinced, both of the success of the measures, which they viewed as optimistic, and of the ability of a fractured parliament to pass it before the 2027 presidential election. The French-German spread 10y bond spread (the difference between the rate Germany and France get to borrow at) widened to roughly 1.52% (152 basis points) at the time of writing, its highest since 2011, with Moody's reviewing its outlook this month. 

Outlook 

On the debt market 

A financial crisis is unlikely to be the base case scenario. 5.3% yields in the US should be a natural consequence of high nominal growth. (Real year-on-year growth of 2.2% and consumer inflation of 3.4%, plus about half a percentage point in the GDP deflator).  

The US is the biggest and most important debt market in the world, so what happens in New York usually spills over to the rest of the world. And when it hits Europe, it highlights the problem of the high debt and the inability of any European country to print its way out of trouble, as they don’t have monetary sovereignty. France’s 117% debt-to-GDP and persistently high deficits, along with political unwillingness to tackle them, make the country a natural target.  

However, these are two separate problems against a week common backdrop: the first is high US yields because of the inflationary boom, and the second is French borrowing, where the former spills into and highlights the latter. This is different from calling the end of the debt cycle that began in 1971.   

Despite certain legal issues, it feels likely that the European Central Bank will intervene, and possibly so will the Fed. They will do so not when governments complain that high borrowing costs limit fiscal space but when they see evidence that market stresses are threatening financial stability.  

The C-suite, however, should not mistake what will likely be a respite for a reprieve. The problem remains very much alive; France is considered one of the riskier borrowers, and 2027 could see markets severely testing its resilience. US debt interest payments at 4.2% of GDP are essentially ⅔ of annual nominal GDP growth. Countries like Greece and Italy, even if they remain on a strict fiscal path, are also being pressured by markets. So is the UK, whose budget announcement later in the month is closely watched by markets.  

On the global economy 

The economy is experiencing an AI- and defence-led capital expenditure expansion, running into supply limits and delivered with minimal hiring. The weak links are consumer-facing margins and how much of Q2's earnings strength was flattered by refunds. While earnings have been good, the case for them continuing is getting more difficult. As inflation rises, challenges to margins and profits will also increase.  

The US is performing well, and European economies have managed to avoid recession. Taking into account growth, however, businesses should also be mindful of the non-linear risks attached to the forecasts. Presently, most economic projections come with a low level of confidence, as they are dependent largely on two factors: AI-related capital expenditure and developments in the Middle East. Employment conditions are looser, and inflation pressures are building up. Trade policy uncertainties are putting more question marks on the economic outlook. A possible slowdown due to a bottleneck in tech spending or protracted disturbance in the Persian Gulf could significantly exacerbate the economic outlook. The problem comes from the lack of safety net. Elevated inflation reduces the possible scope of monetary policy to help with a “growth accident”, and higher borrowing costs restrict governments’ abilities to help with pro-cyclical fiscal policies.  

On the oil market 

Refiners can absorb oil price fluctuations, but when they operate beyond capacity, they may prove less resilient.  That said, an eventual muddle-through still seems likely. Just as the Ukraine war didn’t cause a global famine, which was predicted at the time, the Iran situation isn’t yet causing a global energy crisis or a recession. Oil, evidently, finds some ways to go through, albeit at a much slower pace. However, it’s impossible to ignore the widening of the consequences of prolonged conflict in a complex global supply chain environment, and a resolution is still required. Consequences are not just broadening but are becoming more unpredictable, and businesses should make sure they are prepared for such an environment.   

On monetary policy 

Central banks are expected to tighten interest rates modestly until mid-2027 but not undergo a full rate-hiking cycle.  

For almost four decades, the U.S. Federal Reserve, the “pacemaker” of global financial markets, has operated under a familiar framework of market accommodation. That era is now giving way to a new regime: no longer accommodative until it has exhausted every option, but apparently genuinely committed to its anti-inflation mandate and to a more limited role in public life. A more hawkish Fed means higher short-term interest rates than in the past, particularly if the government continues to favour short-term borrowing. But the good news is that global debt markets may see some credibility restored to longer-dated government bonds, which is very important in this mature part of the debt cycle. An inflation-fighting Fed could restrain long-term debt costs from getting out of hand, which should be positive for all markets, not just US Treasuries. From a strategic planning perspective, healthy businesses are not expected to face a shortage of credit or healthy government balance sheets to suffer. 

What this means for the financial sector 

Positive outlook 

The more hawkish stance of central banks that is unsettling debt markets is, for most of the financial sector, a tailwind. European banks have now beaten earnings expectations for 16 consecutive quarters, and consensus forecasts compiled by Bloomberg Intelligence point to earnings growth of 14% in 2026 and 13% in 2027, making financials the largest contributor to European earnings growth. Net interest income is rising on accelerating loan and deposit growth and wider margins, a trend that modest rate hikes into mid-2027 should extend, while cash returns to shareholders are expected to reach a record €228bn this year. UK financials (8% earnings growth expected in 2026) and Japanese banks (mid-teens) tell a similar story of rate normalisation. In the US, the outlook is moderately positive, with strong investment banking and markets revenue, healthy capital and manageable credit trends, although provisions could rise should employment soften. 

Duration contingency 

The principal caveat remains duration risk, and it has grown since last quarter. The jump in US long-term yields after the weak 5-year auction, as well as the widening of French spreads, undermine the scenario the sector had been counting on, in which falling rates would gradually erode unrealised losses on bank and insurer bond portfolios. Should central banks move beyond modest tightening into a 2022-style hiking cycle, those losses could resurface as a tail risk, as 2022-2023 demonstrated. In Europe, where they peaked at €124bn on ECB data, the damage would be greatest where banks hold large amounts of their own government’s debt. Beyond a certain point, higher rates crystallise mark-to-market losses and test the weakest borrowers. That is the point at which the sector’s positive leverage to higher rates inverts. 

Valuation and structural risks 

Valuations are the second consideration. European banks now trade at a premium to their long-term average price-to-earnings ratio, with most re-rated above tangible book value. At around 10.8x forward earnings, the sector is no longer cheap, although strong profitability and earnings momentum leave room for further re-rating. Growth is also set to decelerate across most financial industries next year, least in capital markets and financial services and most in insurance. Longer term, two structural forces deserve attention: stablecoins, which threaten to disintermediate bank deposits, and AI adoption, where large institutions deploying at scale are widening the productivity and cost gap with smaller ones. 

Bottom line 

The base case for the financial sector remains constructive: margins supported by a higher-for-longer plateau, benign asset quality, solid cost control and record shareholder returns. The risks largely mirror those of the wider economy (geopolitics, trade policy, the rate path and a softening labour market), with valuation now an added consideration. The asymmetry sits in duration. A sustained back-up in yields is the single variable on which the sector’s otherwise improving outlook could turn. 

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