Duncan’s Economic Blog

The Bond Market & Politics

Posted in Uncategorized by duncanseconomicblog on June 9, 2009

I have a strange obsession with gilt yields – and what’s more, I think my readers should too.

Most people reasonably familiar with economics can quite happily discuss inflation, unemployment, GDP growth and are aware of the effect of monetary policy (through rate changes) and fiscal policy (through taxing and spending). But even people very comfortable with economics are often unaware of what a ten year UK government bond (a gilt) is currently yielding.

I find this lack of interest baffling. Only by knowing the cost of government borrowing can what assess how much room for maneuver there is on fiscal policy. If one is unaware of the gilt yield then other widely cited statistics become meaningless: which country is more likely to have funding problems – one with a debt to GDP ratio of 40% or one with 100%? Depends entirely on the gilt yield if in the first case the yield is 12% and in the second only 4%, then the interest cost in case one is 4.8% of GDP whilst it is only 4% in the second.

To my relief, awareness of gilt yields is slowly seeping into the political world. To my horror, a lot of rubbish is being talked.

Let’s start with a chart. Showing the gilt yield over the past twenty years. It gives a bit of context.

uk 10

Between 1989 and 1998 yields fell and then were range bound from 1998 until last year. After a sharp fall in 2008, they have ticked up again in recent weeks.

But looking at that chart it doesn’t look like the ‘markets’ are saying Britain is going broke! They are still prepared to lend to the government on ten year terms for less than 4%.

Charlie had an excellent post up a little while back outlining the ‘nightmare’ scenario which is the international markets calling time on the whole thing and refusing to lend to the Government. We are a long way from that.

Fraser Nelson at the Spectator seemed to believe we were nearly there back in March.

Given the Tories have been banging the drum about how unsustainable the UK’s fiscal position is, the failure of gilt yields to soar must have caused much scratching of heads at Conservative Central Office.

The ever inventive George Osborne has come up with a new line to explain this.

George Osborne, who welcomed his party’s “massive lead” over Labour in the dual elections, will assert today that the assumption the Conservatives will take power within a year is a prime factor in reassuring international investors, concerned by the current political chaos.

The shadow chancellor will state that the usual assumption that re-electing the incumbent party is the safest option has been “turned on its head by the markets – re-electing Labour is now the risky choice”.
Mr Osborne will tell an Association of British Insurers conference today that his party’s “reputation for fiscal responsibility is already helping the recovery by shaping market expectations for the cost of government borrowing and debt in 12 months’ time”.

So, if gilt yields go up that’s because Britain is about to go broke and if they stay the same or go down, that’s thanks to the Tories. Curious.

What is being totally excluded from the political debate on gilt yields is the simple fact that the level of gilt yields is not solely determined by the prospect of default and the state of the public finances.

Of course these factors matter. But the UK is not going to default on its debt. No one realistically thinks it will.

There are a vast number of factors that determine yields – the expected rate of inflation, the likely course of short term interest rates, the perceived strength of the economy, the attractiveness of other assets – not to mention technical reasons such as pension funds matching their liabilities to long term, stable assets.

So here’s another chart. Gilt yields since the start of the credit crisis in August 2007, along with US, German and Swedish 10 year bond yields.

bonds
The obvious take away here is that all four are moving together. So are Canadian government bonds, French ones, Japanese ones… indeed pretty much most of the industrialised world’s bonds.

The point I am slowly labouring towards is this: the moves in UK gilt yields over the past weeks, months and even years tell us almost nothing about the prospect of default and the markets’ views on the Government. The Tories can scaremonger and moan all they like, but they are at best wrong and at worst dishonest.

If UK gilt yields head northwards whilst other yields stay the same or fall, then the markets will be telling us something. But at the moment, that isn’t happening.

8 Responses

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  1. Paul said, on June 9, 2009 at 12:26 pm

    Interesting stuff as ever. Why do you think US 10 year bond yield rates dipped farily sharply to 2% in early 2009? Was that linked to the arrival of Obama in the White House and announcements about fiscal stimulus?

    • duncanseconomicblog said, on June 9, 2009 at 12:43 pm

      Hi Paul,

      I think – the start of the Fed’s quantitative easing programme (the Fed had been signalling this since late 2008), coupled with a large stock market drop (bonds thereby becoming more attractive, so prices up and yields down) and a very real worry about deflation – in which bonds tend to outperform.

      The interesting thing is, rising bond yields can be a good thing. If the world economy recovers then investors will move out of bonds (driving yields up) and buy stocks. That seems to be what has been happening over the past few weeks since March, as people become more optimistic.

      Whether the optimism is justified remains to be seen.

  2. CharlieMcMenamin said, on June 9, 2009 at 2:04 pm

    Dunc,
    It’s fine to expose the Tories’ scare-mongering. It’s fine to point to international comparisons which are broadly in line with British experience. it’s fine to imply that the short-medium term problem is battling against deflation and unemployment, not worrying about a immediate government deficit.

    But…

    All that depends on the assumption that the current gap between tax take and spending can, over time, be closed through some combination of tax rises, public spending cuts and/or, possibly, inflation. You yourself have pointed out the current gap is equivalent to roughly 25% of all public spending or a across the board 30% rise in taxes in a previous post. So I think it does remain true in a slightly longer perspective – let’s say the next 10 years, beginning, perhaps, the day after the next general election – that this matter is likely to dominate domestic politics, and clearly has the potential to ‘spook’ the bond markets if there is widespread resistance to either tax rises or public spending cuts. (Which is why the supposedly technical debate about the status of these much hyped ‘greenshoots of recovery’ is so politicised.)

    Furthermore, some of us harbour doubts about whether it is ever going to be either sensible or possible to fully restore the international position of the City and its former predominant role in our national economy. It is entirely possible that any British recovery comes later or and/or less convincingly than the eventual recovery in other countries – this might mean the comparative yields on government bonds stop moving in the international lockstep your chart shows.

    So, yes, current government policy is clearly better than Tory policy. But that doesn’t mean that there aren’t huge structural strains ahead, because there are. The only ‘get out of jail free card’ I’ve read about comes in the form of a belief in the upswing generated by a New Long Wave, which through the widespread adoption of new bundle of ‘game changing’ technologies and business processes, unlocks a new era of growth unprecedented in recent decades. Well, let’s hope so. But I remain to be convinced, though I’m open minded about this..

    • duncanseconomicblog said, on June 9, 2009 at 2:15 pm

      Charlie,

      I totally agree that the long term challenge will be restoring finances to health – and yes that will take colossal moves in spending and/or taxes.

      You’re totally right to think this will dominate politics for a decade.

      I was more speaking about the short term in this post (call it 2/3 years). Neither Labour nor the Tories yet seem to ‘get’ this. Both pay lip service to the issue but neither has yet spelt out a creditable plan for balancing the books in the medium term.

      I can understand why. Neither option is at all politically appealing. But you’ve been right to note that in the medium term if such a plan does not emerge, then the international markets will simply call time and stop lending to us.

      I do worry that this issue will simply be skirted over in the election campaign, where as I think both main parties should be honest with the public about how they intend to deal with the situation.

  3. CharlieMcMenamin said, on June 9, 2009 at 2:26 pm

    Dunc,
    Of course the real issue will be avoided in the general election campaign. Which people will then hugely resent when faced with cuts and tax rises and disappearing pensions. Which had the clear potential to undermine any remaining popular faith in our system of representative democracy far more than a few spates about expenses.

  4. VinoS said, on June 9, 2009 at 4:48 pm

    Re gilt yields, I always assumed that they are low because inflation is low. If we are in a deflation situation, then a 2% yield may be a 3% real one.

    I agree there are long-term issues about whether a govt can borrow 10+% of GDP for more than a year or two; but, assuming it can be reduced below this, then there is not much danger of default. A gov’t with a growing economy should be able to have a slight deficit for capital investment projects that keeps being incurred.

  5. CharlieMcMenamin said, on June 9, 2009 at 5:22 pm

    VinoS,
    Ah yes, that growing economy that can afford continual sizable capital investment. I’m looking forward to seeing that. I just don’t know when it’s likely to arrive in any meaningful way, and I keep stumbling across voices who warn me that the supposed greenshoots may contain their own problems :

    “Many professional investors have concluded the policy response to date has once again reset the game. Bank stocks have doubled since their lows, and US equity indexes are up 30-40% since early March. A rise in interest rates and commodity prices is certainly typical of economic recoveries, but this has not been a typical recession. The housing market damage is unprecedented; so too is the dramatic shift of households to a higher saving rate and a net reduction of household debt. The fact is that housing and consumer durable spending historically have tended to lead the US economy out of recession. The higher mortgage rates and higher gas prices resulting from investor reactions to the policy push may get in the way. They are salt in existing wounds. Perhaps the fiscal thrust is so large this time around that a recovery can be led by different sectors like infrastructure and technology and a Japanese style stagnation can be sidestepped. On the above analysis, however, the way forward may be a bit trickier than many investors now expect.”

    http://www.nakedcapitalism.com/2009/06/policy-complications-ahead.html

    I’m far from convinced we’re out of the wood yet: as the quote says, Japanese style stagnation remains a possibility.

  6. […] Interest rates on guilts have stayed low in the UK, strongly suggesting continued confidence in the UK economy in the long term.  This is a good […]


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