Westpac: AI and Fiscal Deficits to Keep Bond Yields Elevated

Westpac Economics has laid out the case for a persistently higher global structure of interest rates, one driven by the AI investment boom, US fiscal incontinence, and structural shifts in saving and investment. The bank's analysts argue that the pre-pandemic period of low rates was an aberration, and the forces pushing yields higher are likely to persist for years.

In a note published this week, Westpac's team said the global balance of saving and investment has shifted decisively. Pre-pandemic, high official-sector reserve accumulation kept saving rates elevated, while investment was weak after the financial crisis. Banks were recapitalising, governments were in austerity mode, and the new technologies of the 2010s did not spark the same kind of productivity boom as computers and the internet did in the late 1990s. That period, Westpac said, was an outlier.

"A range of forces have been pushing neutral rates higher," the bank's economists wrote. Those include higher government spending as populations age, the need for private-sector investment in energy transition and AI, and increased defence spending -- especially after Germany changed its constitution last year to allow more deficit spending. The US federal government's fiscal position has worsened under the current administration, with deficits exceeding 6% of GDP since early 2023.

Westpac broke down the bond yield into its components: expected inflation, real yields, and the term premium. All three are now higher than in the 2010s. Inflation undershot central bank targets for most of the last decade but has since run at or above target, driven by global supply shocks. Real yields have turned positive across the maturity spectrum, compressing the "search for yield" behaviour that had previously pushed term premia and risk spreads lower.

The scale of AI-related investment is a key driver, Westpac said. The planned global spending on data centres is "mind-boggling" and is creating substantial demand for debt finance. The large technology firms known as hyperscalers -- Alphabet, Amazon, Meta, and Microsoft -- used to be enormous cash generators. Now they are among the largest corporate bond issuers. Alphabet completed a super-sized $A-denominated deal this week, and Westpac noted that issuance in Australia and other non-US jurisdictions makes sense because the firms want to access a diversified investor pool and because many of the assets they are financing are outside the US, especially as data centres have become politically unpopular in some US communities.

"The scale of this greater investment call on global savings is one reason to expect longer-dated yields to average even higher in the near term," the bank said.

But Westpac also cautioned that the AI boom is likely a cyclical phenomenon that will settle down as the technology matures and computing capacity expands. The US government's deficit, by contrast, looks more structural. The federal government has run deficits above 4% of GDP for a decade, with a brief exception in 2022, and the current trajectory shows no sign of reversal.

Investor discontent with US fiscal policy has become visible in recent weeks, Westpac said. The bonds of hyperscaler companies, including the $A-denominated ones, now offer higher yields than US Treasuries, despite similar credit ratings. Australian government bonds also look attractive by comparison. Japan, meanwhile, is becoming a "normal" economy with positive inflation and interest rates, and an undervalued currency that may draw investors seeking appreciation. While there is no alternative to US Treasuries for depth and liquidity, Westpac said diversification out of USD assets is starting to look both more feasible and more attractive.

For Australia, the long end of the yield curve is less relevant than the short end, since most financing, especially for households, is short-term. But governments and the local firms involved in data centre construction are affected. Westpac noted that the US government's rising debt-servicing costs are already constraining policy. In recent weeks, the Treasury has conducted unusual currency interventions and buy-backs designed to shorten the maturity profile of its debt, aiming to lower the term premium. Westpac expects more such manoeuvres, but called them stop-gaps, not lasting solutions.

"We can imagine the content of the phone calls between FOMC Chair Warsh and President Trump," the bank said, adding that the Fed is unlikely to fold under pressure to keep rates low. The only durable fix, Westpac concluded, would be genuine fiscal consolidation.

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