The really big question in UK economic policy: What are low gilt yields telling us?
It’s now quite commonly accepted that the UK economy’s most immediate problem is a shortage of demand. Over the past year domestic demand has collapsed as firms haven’t invested, the government has begun its austerity programme and a squeeze on living standards has led to a fall in household spending.
None of this is to deny that the UK also faces supply side challenges (ones that are highly unlikely to be met by the Coalition’s agenda of deregulation and tax cuts) but the pressing problem is on the demand side.
The big political-economic debate is on the merits of an immediate targeted, timely and temporary stimulus now versus sticking to tough austerity. The IMF, in common with most international economic bodies, argues that what is needed is stimulus now and fiscal consolidation later. The Coalition says ‘there is no alternative’ to its austerity.
The OBR, as Nicola has pointed out in a ‘must-read’ blog post, doesn’t entirely sign up to this. Their most recent forecasts emphasise that there is spare capacity in the UK economy – i.e. there is room for a fiscal expansion to improve demand and drive up output and employment without increasing inflation.
In the end much of this comes down to an argument about how the bond market would react to such a move. Here again Nicola’s post is worth reading – the OBR themselves point out that even a 1.5% increase in UK gilt yields wouldn’t have a huge impact on the UK’s debt position. The long term maturity of the UK’s debt insulates us from short term market moves.
At root then much of political-economic battle has been a fight about why the UK’s bond yields are at an historical low.
Here we get two competing explanations. The one preferred by the government – the UK is a safe haven and so the market is so confident it will lend to us at record low interests and the one preferred by its opponents – low interest rates aren’t a sign of huge confidence in the UK government they are instead a sign that the market is very pessimistic about growth and so thinks interest rates are likely to remain low for an extended period.
Proponents of the government’s ‘safe haven’ view tend to look at UK bonds yields and assume that they only reflect’ credit risk’, i.e. the risk of default.
The higher the perceived credit risk, the higher the rate of interest that investors will demand for lending their capital. Credit risks are calculated based on the borrowers’ overall ability to repay. This calculation includes the borrowers’ collateral assets, revenue-generating ability and taxing authority (such as for government and municipal bonds).
They completely ignore ‘interest rate risk’, the risk that the value of a bond will be changed by changes in wider interest rates.
As interest rates rise, bond prices fall and vice versa. The rationale is that as interest rates increase, the opportunity cost of holding a bond decreases since investors are able to realize greater yields by switching to other investments that reflect the higher interest rate. For example, a 5% bond is worth more if interest rates decrease since the bondholder receives a fixed rate of return relative to the market, which is offering a lower rate of return as a result of the decrease in rates.
I would argue that in the case of UK government debt interest rate risk is far more important than credit risk. No one is seriously arguing that there is the remotest chance that the UK will default. It therefore stands to reason that the pricing of credit risk is negligible. The determining factor of bond yields in the UK then is not the chance that the government might default (hence the lack of a market reaction to the OBR’s pronouncement that the government will borrow £158bn more than it originally intended) but the outlook for wider interest rates.
All things being equal if the economy was expected to perform well then interest rates would start to rise from their current historical low and bond yields should start to rise. The current low level of yields then is a warning about weak growth prospects rather than a ringing endorsement of the government’s economic strategy.
If the government were right and it was indeed credit risk rather than interest rate risk than determined sovereign bond pricing (in countries with their own currency, I fully accept the case in the Eurozone is different) then one would have expected US yields to rise following S&P’s downgrade in August.
Government bonds have returned 4.4 percent, the dollar has gained 8.6 percent relative to a basket of currencies, and the S&P 500 Index of stocks has rallied 1.7 percent since the U.S. was cut to AA+ from AAA on Aug. 5. The cost for the nation to borrow has fallen to record lows since S&P said the U.S. was no longer risk-free, with the average monthly yield in November on 10-year notes below 2 percent for the first time since 1950.
The chart below compares the quarterly average yield of 10 year gilts to quarterly economic growth in the UK over the past 27 years (the Bank of England only publishes quarterly average yields back to then).
It certainly gives no indication that the current low level of government bond yields should be taken as sign of success.
Notice how between March 2008 and March 2009 as the economy contracted by a staggering 5.5% yields fell from 4.5% to 3.5%. By the current government’s preferred analysis this reflected a huge vote of confidence in the then government’s policies and economic management.
If the government really believe their ‘safe haven’ rhetoric then it is incumbent on them to explain why the UK is currently viewed as the safest investment it has been since the mid 1850s despite high and rising unemployment, a near record deficit and the slowest recovery since the 1930s. It make little to no sense as serious analysis.
If instead the primary reason for our low rates is indeed wider worries over economic growth than not only is there the economic space in terms of spare capacity for a temporary boost to demand but it is also unlikely that the bond market reaction would be negative.