Fiscal vulnerability

The chart below plots a fiscal vulnerability index against the "yield gap" (10-year yield minus nominal trend growth) for 35 high-income economies. Three things stand out:

🔹 France and Italy are already paying up. Both sit in the high-risk zone with yield gaps around 2.5pp. The market has repriced them, and France has seen one of the sharpest rises in 10-year yields this year.

🔹 Belgium is the outlier. It sits firmly in the high-risk zone, but its yield gap (~0.9pp) is well below what the fitted line implies for its vulnerability. Either the fundamentals are forgiven or the repricing is still ahead of us.

🔹 Japan, the US, Greece and Canada also sit in the high-risk zone. Switzerland, Denmark and Norway are the safe havens.

Why this matters beyond bond markets:

1. Long yields. Weak fiscal positions mean more supply and a higher term premium. When investors lose confidence in the path of debt, they demand compensation, and repricing tends to come in jumps rather than smoothly

2. Short-term rates. Central banks get squeezed. Cutting into fiscal stress can steepen the curve and weaken the currency. Holding rates high raises debt-service costs and worsens the deficit. Either way, the room for policy easing shrinks.

3. Inflation. If markets doubt that deficits will be closed, risk premia rise, currencies weaken and imported inflation follows. In the extreme, fiscal dominance makes the central bank's job much harder.

4. Growth. Higher yields feed through to mortgages and corporate borrowing costs, while governments are forced into tax rises or spending cuts. Public debt service also crowds out investment and services.

The takeaway for investors: fiscal risk is a slow-burning story until it isn't. Differences in vulnerability are not yet fully priced across countries, so duration, currency and sovereign credit exposure deserve a closer look. Bond yields and currencies in certain economies wil be under pressure for a while.

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