As you can see from the chart below (or perhaps not given the quality of the reproduction, for which apologies), UK government bond yields have fallen to historic lows the depths of which even six months ago would scarcely have been believable – less than 2.5pc on ten year gilts. These are the sort of levels that until recently only ruled in Japan.
Those of us who have been calling the top of the bull market in bonds for the best part of the last two years are left with egg on our faces. I’m hardly alone. Step forward Bill Gross, John Paulson, Jim Rogers and a litany of other self styled market “experts”. And those who got it right? Well I hate to pay him the complement, but among others Paul Krugman, whose religiously preached Keynsian analysis of the crisis has, in this regard at least, been spot on. For this is not just a UK phenomenon. It’s happening just about everywhere, bar the troubled debtor nations of the eurozone, where the very real possibility of default has sent bond prices in the other direction.
If you believe much of the European press, rising bond yields in Italy, Spain and much of the rest of the eurozone even as they plummet virtually everywhere else is all an Anglo Saxon conspiracy designed to sink the euro. (See the excellent blog by my colleague, Ambrose Evans Pritchard, for more on this) Why won’t the bastards lend to us, they ask? It is because you don’t have the natural corrective of a floating exchange rate, is the answer, but Europe’s political class refuses to listen.
So why is this happening? Why is it that despite ever more mountainous government debt, investors want to keep buying into the non-eurozone version of it? There are three things going on here. The first is that central banks have set short term rates at close to zero in an effort to stimulate demand, and judged by comments from the US Federal Reserve and the Bank of England this week, look set to keep them there for at least the next two years. A more hawkish tone has been set by the European Central Bank, which in part explains why the bond prices of debtor eurozone nations are doing so badly, but in the round, policy is being kept as stimulative as it can.
In the hunt for yield, that drives money out of short term deposits into near cash equivalents such as longer dated government bonds, which in turn drives down the yields on those bonds.
Second, the market has begun to anticipate further bouts of “quantitative easing”, or purchases by central banks of government bonds, both in the US and Europe. If the purpose of such purchases is to drive yields lower in the hope that investors will either spend or invest the money in higher risk assets, you kind of wonder whether there’s any sense in doing any more. Bond yields are sinking without any help from central bankers. But in any case, markets anticipate more of it.
Yet the single most important factor that underlies all this is that when householders, businesses and the financial sector aren’t spending and investing, a savings surplus accumulates which has to go somewhere. In the search for safe havens, it goes first and foremost into government debt, where it is used to provide the demand which the private sector has decided to remove. When governments attempt to reduce their demand for debt, as is beginning to happen at the moment with fiscal austerity programmes, you get a self feeding pressure of excess demand on limited supply, and yields fall even further.
What these yields are pointing to then, is a depression. In such an environment, corporate profits will suffer and insolvencies will rise. Equity markets suffer accordingly.
If I was a Treasury mandarin, I’d be urging the Chancellor to bring forward his debt raising programme to take advantage of these extraordinarily low interest rates. I doubt the chance to lock in long term debt at rates of as little as 2.5pc – way below the current, near 5pc, inflation rate – will occur again for an awfully long time.
But of course, the Treasury cannot do this. In the interests of transparency, it has already announced how much it is going to raise and in what form for this financial year. The next opportunity for altering that schedule is not until the Autumn statement. You can see the amount of debt the Government is planning to issue this year from the table below – in gross terms, it is already a new record.
And as the second table shows, despite ever more voluminous issuance, the amount the government is paying for its debt has been falling steadily.
George Osborne, the Chancellor, likes to see this phenomenon as a vote of confidence in his deficit reduction strategy. Unfortunately, that’s only part of the story. As I say, they’ve had similar yields in Japan for years now, with no sign of a credible deficit reduction strategy in sight and public debt spiralling up towards 250pc of GDP.
Unfortunately, low gilt yields are more indicative of impaired private sector demand than they are of Government resolve. What the economy appears to need, and I really do hesitate to say this, is a good old fashioned bout of inflation, but then we’ve already got that in the UK, and to perpetuate might seem only to replace one problem with another. Yet there are few more effective ways of eroding the doomsday machine of excessive debt.
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