There are many factors which determine what happens in a government bond market and today I intend to explain what is going on and why this matters to individuals. As 2012 has moved into 2013 we have seen some changes which I think are significant and may even be the beginning of a reversal of a trend in many of them that has existed for my career in financial markets. In fact it has been around for so long that I suspect it has morphed into the background and become regarded as part of the “natural order”. Also the credit crunch era gave it another shove firstly from the economic slowdown it caused and secondly from the policy responses of cutting short-term interest rates and Quantitative Easing.
Short-term and long-term interest rates
Let me explain the position by looking at short-term interest rates or what in the UK are called base rates. The official rate is set by the Monetary Policy Committee of the Bank of England but the 0.5% only holds in literal terms for overnight or 24 hours. As it meets monthly you could argue that in general it lasts for a month although it can in emergencies change that.
So what about everything after a month? This is what you may read as the yield curve and borrowing rates here in an economy are influenced heavily by what the government borrows at. For example whilst the media obsesses on base rates not many mortgages are for a month are they? Think of company borrowing too. Ironically something which you may think of as overnight borrowing such as an overdraft is way over the base rate! But you can blame the banks for that.
But returning to the yield curve and longer-term interest rates the UK can borrow at just over 1% for five years, 2.2% for 10 years and 3.52% out to 2060 which is our longest dated conventional Gilt. As you can see these are very different to base rates and much economic activity will be based on them.
It would be wrong to say that base rates have no influence on the interest rates here particularly at the shorter dated end of the spectrum. But it is also true that it can have an inverse effect as for example base rate cuts leading to fears of over expansion and inflation leading investors to ask for higher bond yields.
An enormous effect on economic growth
I remember asking a fund manager back in the late 1980s when I was what the Americans call green why they were buying UK Gilts at 15% yield. If I now tell you that an equivalent Gilt right now would yield 3% you get an idea of the enormous bull market for bond prices and bear market for yields that has taken place since. Over this period this has given an extraordinary stimulus to economic growth although it very rarely gets given its due credit or a proper name check. There are always plenty of people available to claim the credit for good news!
The rest of the world too?
To say everyone or everywhere is far too sweeping a statement but if we use the United States as another example we see that the same principle and trend has been in existence. Her long bond (30 year) yield peaked at around 13% in the early 1980s and is 3.18% now giving us a rather similar theme,trend and pattern. So a clear boost to economic growth there too and plenty of other examples are available.
Why discuss this now?
Bond yields have backed up and have been rising rather than falling with the UK being a relatively extreme case of this. Our benchmark ten-year yield dipped to 1.46% late last summer but has pushed over 2.2% this week so there has been a considerable move. If you will be kind enough to excuse the geekery it was significant that our longer dated Gilts saw yields below 3% back then but are now as you can see up to 3.5%.
So we see that there has been a contractionary influence on the UK economy since last summer as these bond yields have risen.
Okay why might this be?
Let me quote from a Bank of England working paper from May 2000 on this subject.
We conclude that much of the decline in long gilt yields can be attributed to a decline in UK inflation expectations since the mid-1970s
As the current hapless crew at the Bank of England have been stoking up inflationary expectations in recent times we can see that their predecessors would have feared (correctly) as to what might happen in the UK Gilt market in response. The Bank of England’s own measure of inflation expectations had been rising before it announced this on Wednesday.
Inflation is likely to rise further in the near term and may remain above the 2% target for the next two years……..Attempting to bring inflation back to target sooner would risk derailing the recovery and undershooting the target in the medium term
If you wished to set off more inflationary expectations then that is the way to do it! If I had been there I would have asked “recovery what recovery Governor? Well once I had stopped laughing at this bit, “undershooting the target.”
But the “old” Bank of England paper has more.
However, we find evidence to suggest that gilt yields have more recently also fallen in response to a significant reduction in net gilt issuance combined with an increase in demand for gilts from UK institutional investors
Or to put it more simply supply and demand matters! If we look at that we see that the UK is supplying lots and with her disappointing fiscal deficit effort over the past year is likely to issue more than previously expected. Against that some aspects of demand have dropped as for example new Quantitative Easing purchases stopped at a total of £375 billion late last year. The effect of QE is not over as in March some £6.6 billion of maturing holdings will be recycled in what is a mini Operation Twist but it was £1 billion a day even if it was only a three day week at the Bank of England.
So we have been seeing more expected supply and in some areas a reduction in demand.
We see plenty of the themes established by this blog enmeshing together today. The usually ignored boost from the long established fall in bond yields has for now been reversed. So a contractionary influence has been applied over the last six months to the UK and we are not alone in this as the US long bond fell to a yield of 2.45% late last summer but now yields 3.18%. Slightly different timing and a weaker effect but it is true in Germany as well.
Now we get to an interesting point which is if we take today’s UK retail sales numbers as an example of this.
In January 2013, year-on-year seasonally adjusted estimates of the quantity bought in the retail sector fell by 0.6%,
A clear reverse on the more hopeful signs the UK had hinted at but if we say that higher bond yields may have influenced this we then of course get an interesting response. Today Gilts are rising because these figures suggest a weaker economy and we get a back-flow on my theory. We can move on from second-order effects to third-order ones if these retail sales numbers are used to estimate the UK fiscal deficit as the chicken and the egg disappear into a spin!
Can they rig it? Yes they can (but….)
If we move onto likely prospects we need to face the fact that many markets are manipulated and in bond markets we have seen Quantitative Easing used to push yields lower. Can they do this again? We have moved from yes to maybe as if we look at the United States and what is called QE Infinity we see that in spite of the promises implied in the name US bond yields have risen and not fallen. Whilst by no means all of the US $85 billion per month of purchases goes into the bond market even the bits that do not are likely to be supportive and yet yields have risen and prices fallen.
So should QE restart in the UK we would probably get an initial ”knee-jerk” fall in Gilt yields but I would be watching closely to see if they then started to rise again as I suspect the situation has changed. Timing is always difficult but it feels to me as if something has changed and we know from the Euro area crisis how fast bond yields can shoot up when they go.
This distinguishes me from many economists who feel that markets can be manipulated for ever and that bond yields cannot accordingly rise. The recent evidence is against them after to be fair a decent spell in their favour. The battle may continue for a while as after the recent yield rises we are due a retracement of the move but I know what I expect longer-term. Anyway I have found it a fascinating theoretical argument as their protestations of central banking ominipotence and omnipresence in theory continually collide with policy errors and incompetence in practice.
For those who have followed me for some time today’s post underlines why I was arguing that the UK should “over borrow” whilst yields were so low. Just to be clear this was looking to make the borrowing we were going to have to do anyway cheaper rather than arguing for an increase.
Today’s Retail Sales Numbers
I posted this on twitter and with apologies for the truncated language caused by the 140 character limit the question holds.
How many in the UK are going hungry? UK ONS: food sales fall to the lowest level since April 2004 and this was before