Ask Forstrong: Are bond markets finally forcing fiscal discipline on governments?

Key Takeaways

• Investors are now demanding higher yields from governments with unsustainable fiscal trajectories.

• After years of lagging, capital is rotating into bond markets in nations with improving macro fundamentals—particularly select emerging markets. This marks a secular shift in global capital flows.

• Fiscal credibility, not just interest rate differentials, is now driving both bond and currency markets. For income-focused portfolios, that means it’s time to adapt. Old playbooks won’t cut it in this new environment.

Keeping up with US policymakers these days feels like a full-time job. The latest headline grabber? A Texas bill threatening to slap warning labels on packaged foods—from Skittles to Pop-Tarts—flagging ingredients “not recommended for human consumption.” If passed, new packaging would roll out in 2027, sending shockwaves through the junk food world.

In 2025, government bonds may need a cautionary label too. Never mind Moody’s downgrade of America’s triple-A rating or even Elon Musk’s split from Trump (DOGE was once seen as a beacon of fiscal restraint in the US)—the real revolt is coming from the markets themselves. US 30-year Treasuries have punched back above 5%. Japan’s long bonds just hit their highest yield since records began in 1999. Similar moves are playing out in the UK, Germany, and Australia. Around the world, the long end is in open rebellion.

What’s happening? Bond markets are complex ecosystems—shaped by countless actors including central banks, pensions, insurance companies, sovereign wealth funds, and millions of individual participants. But broadly speaking, nominal growth and bond yields tend to move together over long periods. Higher inflation and stronger growth usually mean higher rates.

But there’s also a deeply-entrenched belief that rising public debt and ballooning deficits inevitably drive yields higher. History tells a somewhat different story. Take the US. Since 1980, America’s debt-to-GDP ratio has quadrupled—from 31% to over 120%. Yet, until recently, long-term yields have steadily declined, in both nominal and real terms. Or consider Japan. The nation’s debt has almost quintupled since 1990 and now sits at 215% of GDP. Japanese bond yields? Stuck near zero for decades. Even in China, public debt has nearly tripled since 2010, while bond markets barely blinked (10-year yields have even quietly slipped below 2% this year).

But recently, something has shifted. Bond yields are now far more sensitive to fiscal excess than ever before. What has changed? First, the pandemic ended the era of low inflation and ultra-easy money. Yields are no longer anchored to the rock-bottom levels of the 2010s. Instead, they’re drifting toward something that looks more “normal.” No one should have ever believed that fixed-rate mortgage rates under 2% or negative rates in Europe were permanent. That era is over.

Yet there’s also a deeper shift underway. For years, near-zero interest rates papered over fiscal mismanagement. No matter how messy the budgets, governments could usually count on growth outpacing the cost of debt. That math has flipped. Trump’s latest “big, beautiful bill,” which passed the House, would tack on at least $3.3 trillion to US public debt over the next decade. Markets are finally paying attention. 

Then there’s the psychology of a second Trump term—arguably more unpredictable than the first. The warning sign? Liz Truss. Her brief tenure as UK prime minister was cut short by a revolt in the gilt market, which saw her unfunded tax cuts as economic fantasy. Trump’s mercurial approach to fiscal policy—part populism, part improvisation—is facing a similar dynamic. Bond markets are now acting as a disciplinarian again (see Super Trend 4 from our annual 2025 outlook, “The Bond Vigilantes Are Back”). 

While bonds may experience counter-trend rallies—especially during risk-off episodes or cyclical slowdowns—the broader picture suggests a structural regime shift, not just a temporary blip.

All of this comes as governments wade into increasingly tricky territory. In a world of rising geopolitical tension and weaponized trade, nations are racing to de-risk supply chains and rebuild domestic industry. Germany is the poster child—cranking open the fiscal taps to fund a much larger defense budget and industrial transition. But there’s a catch. Big investment pushes mean bigger deficits. And higher deficits—especially in a higher-rate world—start to bite. Yields climb. Rate-sensitive sectors take a hit. And risk markets start to wobble.

Looking ahead, the real story is this: global investors are starting to punish longer-dated sovereign bond markets in countries doubling down on fiscal excess. In bond-speak, “term premiums”—the extra yield investors demand to hold longer-dated government debt—are on the rise. And this pressure isn’t limited to bonds. Currency markets are also behaving differently. Nowhere is this more evident than in America. Typically, rising US Treasury yields attract capital inflows and boost the dollar. But during the tariff-driven market wobble in April, yields rose and the dollar fell. That’s new. Historically, stress events—from the 1998 Asian financial crisis to the 2008 subprime meltdown to the 2020 COVID panic—have triggered classic “risk-off” moves and a flight to the dollar. Not this time.

Bond and FX markets are shifting focus—from rate differentials to fiscal credibility. Case in point: the US dollar is down nearly 10% against the euro this year, despite the European Central Bank cutting rates by 75 basis points while the Fed stood pat. US yields are rising, but the dollar isn’t following. Expect this to continue. Global asset allocators need to take note and prepare for this new regime.

Investment Implications: The Bold and the Beautiful

There’s a flip side to all the above. Global investors are starting to reward bond markets that show fiscal discipline and pursue steady, predictable policy. And the data is already confirming the shift. Our friends at National Bank report that global ex-US bond ETFs just saw their highest monthly inflows on record—$4.8 billion—as investors sidestep the perceived risks brewing in US sovereign debt. 

A large share of that capital is flowing into select emerging market debt—an area well represented across Forstrong’s investment strategies. And for good reason. Most EM countries have quietly built more resilient macro profiles, battle-tested by a series of brutal shocks: the pandemic, aggressive interest rate tightening, and a surging US dollar. Through it all, no major EM has suffered a balance-of-payments crisis or fallen into sovereign debt distress. In fact, EM sovereign defaults as a share of global GDP remain near historic lows. 

That said, not all emerging markets are created equal. Our focus remains on those with improving sovereign credit quality, stable external balances, and credible monetary regimes—regions that are increasingly being rewarded by global capital.

More broadly, Western assets are no longer the default destination for EM savings. Trade surpluses are increasingly being recycled back into domestic markets—boosting local currencies, suppressing yields, and lifting local asset prices. Couple this macro backdrop with undervalued local currencies, increasing sovereign credit quality and higher real yields, and EM debt is primed for a long period of outperformance.

These are the dynamics we’ve positioned for in our Global Income strategy—targeting regions with fiscal discipline, high real yields, and improving credit quality. Unlike traditional bond funds with limited diversification, Global Income is tactical, globally diversified, and built for this new macro regime.

Looking forward, investors should stay nimble: include EM debt exposure, keep bond durations short in countries running hot on fiscal stimulus—and, naturally, steer clear of the junk food aisle. 

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