How the AI boom has contributed to a growing economic threat

There was one subject dominating my email inbox after a summer holiday: big shifts in financial market sentiment.

The potential ramifications are actually huge for the global economic outlook, especially countries such as the UK - its ambitions long-choked by concerns over the sustainability of the public finances.

The outlook for UK borrowing costs had stabilised last month after bond market investors - those who lend the government money - welcomed commitments by the new chancellor, John Healey, to stick to his predecessor's tax and spending rules.

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What has changed since is that borrowing costs, as seen in the effective interest rate demanded to hold UK debt, have been on the rise again to the extent they have crept closer towards levels not seen this century.

Why? This has not been the result of anything Andy Burnham and his new administration has done.

It can all be traced to the United States, where the bond market has thrown something of a hissy fit, prompting the US government to intervene.

Bond yields (the effective interest rate demanded by investors to lend money) have jumped since the US-Iran war began in February because high energy prices have pushed inflation higher.

But the activity had intensified in recent weeks amid increased anxiety over the sustainability of US government debt - now above $40trn (£29.4trn) - and the fact there is no end in sight to the costly Middle East conflict.

At the same time, big borrowing by tech giants to build out artificial intelligence (AI) infrastructure, such as data centres, is flooding bond markets with new debt. It's worth hundreds of billions of dollars this year.

This record supply has competed with US bond issuance, helping push longer term US bond yields to levels last seen in 2007 - the year before the financial crisis.

On Wednesday, we saw a clear signal of concern at the bond market tantrum in the Trump administration as the US Treasury announced it was boosting liquidity support for longer-dated securities.

It had the effect of supporting prices and lowering yields, as would have been hoped, but the problems still exist and the effect could well be temporary.

The fortunes of the US bond markets are typically reflected in other developed economies, which is why the likes of the UK, France, even Germany, have not been immune from this spike in borrowing costs.

Not only are elevated yields a problem for governments in raising new money and servicing their existing obligations, but companies too.

The AI-driven stock market rally of recent years is coming off the boil as shareholders fret over values - a concern already flagged by the Bank of England - and increasingly bet on weaker-than-expected returns ahead.

The greatest volatility is being seen in tech-linked stocks but wider sentiment is under pressure too due to the expected hit to growth that comes from elevated costs.

Is a correction overdue?

Nigel Green, chief executive of investment advisors deVere Group, said the behaviour seemed "to reflect a market finally pricing in risks it had spent months choosing to ignore".

He stated: "For most of this year, investors have been happy to look past elevated borrowing costs, heavy government debt issuance, and a genuinely unstable Middle East.

"Complacency like that tends to unwind fast once it breaks, and, also, fast unwinds tend to overshoot", he warned

Higher government borrowing costs traditionally feed in to bank wholesale funding, raising a lender's costs and therefore things like mortgage rates and car loan charges.

The average long-term US mortgage rate stood at its highest level in almost a year this week, despite no move by the country's central bank to raise interest rates.

Inflationary pressures across the global economy, linked to the war, could yet force the likes of the Federal Reserve or Bank of England to act if there was evidence that price growth was becoming embedded in goods and services prices.

Poor harvests linked to summer heatwaves are threatening higher food bills also.

Higher borrowing costs, coupled with the renewed cost of living pressures, amount to a toxic cocktail when you're trying to find more money to fund defence and targeted household support for bills in a looming October budget.

John Healey will hope the bond market's clear message to Mr Trump, to end the war, is heeded - and fast.

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