International credit watchdog Fitch Ratings said inflation trends and associated risks around interest and exchange rates could directly impact credit ratings.
The watchdog advised governments to manage their debt/GDP (gross domestic product) ratios to maintain or improve their debt sustainability.
Fitch noted the Covid-19 pandemic had raised government debt worldwide that is impacting the creditworthiness that is increasingly sensitive to interest rate changes. Base effects, higher commodity prices, personal effects of sectoral re-openings and pandemic-related supply-side disruption contribute to higher inflation in many countries.
“Nevertheless, most central banks are taking the view that the rise in inflation will not last and that now is not the right time to tighten financial conditions,” Fitch stated.
It added, “Longer-term rates matter more than policy rates for fiscal outcomes and debt sustainability, and there is no convincing evidence yet that bond markets disagree with central banks’ inflation diagnosis. The US 10-year Treasury yield — the most important benchmark for global sovereign borrowing conditions — has been below 1.7 percent since early April. Relatively stable country-specific benchmark sovereign yields are currently the rule rather than the exception.”
The debt watcher predicts US inflation and bond yields would rise in the medium term, as higher inflation is a stated policy objective, and the Fed will only react ex-post.
“We forecast US inflation to be 2.5 percent at end-2023 and 10-year Treasuries to yield 2.3 percent, which is still low in a historical context relative to our nominal GDP projection of more than 4 percent. We expect global yields to follow US yields higher, though Japan has shown low yields can persist on country-specific factors for an extended period,” it explained.
Higher inflation leads to higher nominal GDP, resulting in an immediate improvement in debt/GDP ratios, ‘inflating the debt away.’ This is particularly the case if — as presently — a muted response from benchmark yields to higher inflation, thus lowering governments’ actual marginal borrowing costs.