RPT-EXPLAINER-Who are the 'bond vigilantes' exacting a price from Britain's government?

LONDON, May 13 (Reuters) - Britain's long-dated government borrowing ​costs have surged ⁠to their highest since 1998 as concern that a potential change in leadership ​could weaken fiscal discipline unnerves bond investors.

Borrowing costs in the UK and elsewhere have already risen as the oil price jump triggered by the U.S.-Israeli war on Iran has renewed inflation angst.

It's a bad time for ​governments ‌from Britain to the United States and France, all grappling with the need to spend more on the likes of defence and ageing populations after years of financial setbacks.

Yet as they face elevated debt levels, bond ⁠investors' tolerance for loose purse strings is low.

Cue the "bond vigilantes".

WHO EXACTLY ARE BOND VIGILANTES?

The term, coined ⁠in the 1980s, refers to debt investors who seek to impose fiscal ​discipline on governments they perceive as profligate by demanding higher compensation to hold their bonds.

It can also apply to monetary policy. Investors can demand more compensation if they think central banks and governments are failing to contain inflation.

Higher government borrowing costs can spill over into higher lending rates for consumers and companies, putting economic and financial stability at risk if they spiral out of ​control.

WHERE DID THEY ‌GO AND WHY ARE THEY BACK?

Bond markets were placated in the 1990s as U.S. President Bill Clinton made balancing the budget a priority after initial spending concerns sparked a jump in Treasury yields.

In the following decades, central bank bond buying globally played a powerful role in dampening government borrowing costs.

But they are much higher after an inflation surge following the 2020 pandemic, which also raised government spending, along with an energy crisis following Russia's 2022 invasion of Ukraine. Combined with a retreat of central banks from bond buying, it all means bond investors ​now carry more heft.

And the war with Iran has added to the pressure.

Debt is roughly equal to or higher than economic output across the Group of Seven advanced economies, ‌bar Germany.

Click here for Reuters' live dashboard tracking G7 debt.

WHAT ELSE IS DIFFERENT TODAY?

While in the 1980s the focus was inflation, today it is the surge in national debt burdens, analysts said.

While the Iran war is raising inflation, it is not ‌expected to reach levels anywhere near those of 2022, and traders are pricing in a swift response from central banks.

The International Monetary Fund said last month that the U.S. needs a credible plan to reduce its fiscal deficit by about four percentage points of economic output from 7% currently.

In Britain, which has the highest long-term borrowing costs among the G7, investors are worried ​that Prime Minister Keir Starmer, facing pressure to quit, could be replaced by a leader who pushes for more spending.

Japan, the most indebted major economy, is also in the spotlight because Prime Minister Sanae Takaichi's spending ‌plans have rekindled fiscal concerns.

WHERE HAVE THESE VIGILANTES BEEN IN ACTION?

The biggest example is Britain. Borrowing costs surged an entire percentage point within a week in 2022 as plans to slash taxes and raise borrowing spooked investors at a time when national finances were already under pressure. That forced Liz Truss to resign as prime minister.

France has also seen pressure as persistent political instability has ⁠held back efforts ⁠to contain its budget deficit.

Analysts say high debt is among the main reasons why investors demand higher compensation for holding ‌longer-term debt, even from the United States, the world's biggest economy.

SO, THEY REALLY ARE POWERFUL?

Yes and Ed Yardeni, the economist who coined the term, says that is because debt is rising.

The United States has some $30 trillion worth ​of outstanding debt, compared with below $20 trillion before the ​pandemic and less than $5 trillion before the global financial crisis of 2008-10.

So far, bond vigilantes have not had the influence elsewhere that ‌they have had in Britain. The United States' robust economy and the dollar's status as the No.1 reserve currency offer it a buffer, while France's membership of the euro zone gives its bonds some protection.

But that is no reason to be complacent, say analysts, especially as rising borrowing costs add to the cost of servicing existing debt. In 2024, interest payments across OECD countries including the U.S. cost more than national defence.