A TRICKLE here, a trickle there: better news on the economy – here and in America, is now showing through. Why, then, are markets so worried about the recent upsurge in government bond yields?
Movements in the price of government bonds (the higher the price, the lower the yield, and vice versa) reflect the daily summation of millions of investors as to the broader state of the economy and interest rates. As a rough and ready guide, falling
yields indicate investor doubts over equities and an economy that is likely to be slowing. Rising bond yields would suggest a strengthening economy and growing nervousness over interest rates and inflation.
In recent weeks bond yields, both here and in the US, have been rising, leading to two sharply different interpretations. The optimists see this as hugely positive. Deflation and depression has been averted, the dramatic monetary and fiscal stimulus policies of recent months are clearly working and financial confidence is returning.
Not so fast, say the sceptics. Rising bond yields reflect growing worries over the massive debt funding programmes that lie ahead, and the dangers of inflation. If the economy is recovering, then now is the time to put a cap on those stimulus programmes and to halt quantitative easing.
Concern in the UK has been heightened by the dramatic political developments and rising doubts over how long Prime Minister Gordon Brown is likely to remain in office.
The key issue for investors is the interplay between the political situation and UK fiscal policy. On Thursday and Friday, the pound fell sharply – a measure of investor concern. The yield on ten-year gilts is now up to 3.78 per cent – high for an economy whose main inflation measure is showing price deflation. The worry is less over the fate of the Prime Minister as such but the policy implications for the ballooning fiscal deficit, the lack of serious measures to put the public finances back on a sustainable path and (remember this?) the recent warning by ratings agency Standard & Poors that the UK needs major fiscal tightening to maintain its current Triple A rating.
That rating, it warned, "could be lowered if we conclude that, following the election the next government's fiscal consolidation plans are unlikely to put the UK debt burden on a secure downward trajectory over the medium term.
Conversely, the outlook could be revised back to stable if comprehensive measures are implemented to place the public finances on a sustainable footing or if fiscal out-turns are more benign than we currently anticipate."
Bond prices both in the UK and US in recent weeks have slumped and yields have shown a sharp rise. Since late April, the yield on the US 10-year Treasury note has risen from below three per cent to 3.76 per cent. It has eased a little in recent weeks to around 3.5 per cent.
There are certainly sound reasons why investors should take a more sanguine view. Household and business confidence is rising. American consumer confidence is at an eight-month high. On Thursday, the US government reported that the number of people on unemployment insurance fell, albeit slightly, for the first time in 20 weeks, while total jobless benefit rolls also fell, for the first time since January. Friday brought news that US non-farm payrolls decreased by 345,000 in May, a third lower than the consensus estimation of a fall of 520,000. On top of this, figures for both March and April were positively revised, with 82,000 fewer jobs lost in the three months combined than previously reported.
But viewed from another perspective, the rise in bond yields is not so reassuring. This is because of concerns that a huge price in inflation terms will have to be paid for the enormous quantities of debt that governments have taken on and now have to sell to investors. Because of the long relationship between periods of debt creation in the past and subsequent rises in inflation, investors are now demanding higher yields to compensate for the likely fall in the real purchasing power of their capital when the debt matures.
In recent months, the US Federal Reserve has been buying large amounts of Treasury debt in order to drive down the mortgage rate, thus helping to stimulate demand and haul a stricken housing market out of the doldrums. But ironically, the more it does so, the greater the risk that it will stoke inflation fears, thus forcing up the yield on 10 year-bonds. Its efforts to stimulate thus become self defeating.
A similar dilemma faces the Bank of England, with its policy of Quantitative Easing. This involves the purchase of assets from banks, principally government stock, in the initial stages. The expectation was that gilt prices would rise and yields fall. But almost immediately, yields on bonds started to escalate. Investors, worried about a slump in demand for gilts when the purchasing programme came to an end, have been pushing for a higher yield to compensate for the risk of potential losses ahead. Some, such as the British Chambers of Commerce, have been calling for the QE programme to be stepped up to ensure rising gilt yields do not snuff out the recovery. Others say the signal from the gilt market is that QE should now be capped.
This is a real conundrum for central banks, and helps explain market apprehension that the recent rise in bond yields may well become reinforcing in the coming weeks and months.
It was in response to these concerns that Ben Bernanke, chairman of the US Fed, urged Congress last Thursday to act now to bring down long term budget deficits, warning that the bond market was alarmed about US government debt.
In remarks that had strong resonance in the UK, he said recent sharp increases in bond yields "appear to reflect concern about large federal deficits" as well as improved optimism about the economy and other factors. Failure to address the fiscal deficit now, he warned, could result in the US facing a debt trap. "We cannot allow ourselves to be in a situation where the debt continues to rise. That means more and more interest payments which swell the deficit which leads to an unsustainable situation". He said that Congress should try to stabilise the debt-to-GDP ratio at its post-crisis level of about 70 per cent and seek "over time to try and reduce it".
Another concern, however, is that investors are anxious that the huge government deficits generated during the slump will be allowed to continue even after economic conditions improve. The result then might be that confidence in government debt and the financial system will collapse. Stephen Lewis, economist at Monument Securities, says the announcement of the Obama fiscal package, which is set to raise the US government debt-to-GDP ratio to its highest level since the Korean War, did not appear to have much damaging effect on confidence in the Treasuries market. "It seems investors have not yet really taken account of the potential implications for yields of budget deficits on the scale planned. Their focus is short-term… As with the impact of inflation expectations, the worst for Treasuries may yet be to come from the budget deficit factor.
"Investors", he adds, "are unclear how far central banks are distorting markets and there is no visibility regarding the exit strategies, if any, that the Federal Reserve and Bank of England will adopt." As government yields rise, there are louder calls for them to step up their asset purchases. The implied threat, if they do not, is that yields will soar, undoing much of the work they have put in to revive the economy. "The logical end of the asset-purchase programmes", Lewis warns, "is that central banks end up owning all outstanding government securities. Only then would the danger of disorderly markets, when the central banks stop buying, be eliminated."
Little wonder central banks find themselves in a policy bind, and that those rising yields are being watched with some apprehension, not least here in the UK, where political convulsions may have caused parliament and government to overlook the substantial spending cuts and tax rises that are now urgently required to save our credit rating.
