Bond vigilantes are a threat to Britain’s public finances
In 1998, James Carville, then President Bill Clinton’s chief strategist, famously said: “I used to think that if there was reincarnation, I wanted to come back as the president or the Pope or as a .400 baseball hitter. But now I would want to come back as the bond market. You can intimidate everybody.”
Liz Truss and her chancellor, Kwasi Kwarteng, experienced the wisdom in this quip. We could be entering another period when what happens to British government bonds, known as gilts, will again be at the epicentre of a gathering economic crisis.
Over the years, gilt yields have been on a rollercoaster. I can remember when, in 1979-80, gilt yields breached 17pc. Yet, at the low point in August 2020, 10-year yields were down to 0.04pc. Remarkably, in some countries bond yields even turned negative. Over the last year 10-year gilt yields have been standing in a range of 3.5pc to 4.7pc. But over the last few weeks, they have ticked up. At the end of last week they stood at about 4.5pc.
For many readers, what happens to gilt yields may seem somewhat arcane. Yet they are a critical variable. They affect us in three major ways. First, they are the yardstick for the valuation of all sorts of assets, including equities and property. For the latter, it is 10-year yields that are most often used.
Second, they affect the terms of borrowing for just about everyone, including companies and households. For households, the effect is most acute in relation to fixed-rate mortgages. And in that regard it is two and five-year yields that matter most.
Third, gilt yields determine the cost of government borrowing, as well as the cost of refinancing existing debt.
So what drives gilt yields? It is widely believed that the key variable is the amount of government borrowing, which determines the amount of gilts issued. After all, other things equal, when supply increases you would expect the price of bonds to fall, which then increases their yield. And there is something in this, although when the economic conditions are right, the bond markets may absorb almost unlimited quantities of government debt without turning a hair.
Most importantly, on many occasions other things are not equal. During the pandemic, for instance, government borrowing shot up to 15pc of GDP. Yet gilt yields fell to record lows.
The second major influence is the level of official short-term interest rates, which is set by the Bank of England. The influence of the current rate, presently at 4.75pc, is felt most strongly on short maturities. The further you get away from short-term maturities, then the smaller is the influence of the current rate and the greater the influence of expectations about future rates.
This brings us to the third major influence, namely inflation. Here too, it is not the current inflation rate that the markets focus on but rather the rate that they expect over the life of the bond. Current rates are only relevant in so far as they influence those expectations.
In this regard, last week’s data releases were less than helpful. Inflation rose from 1.7pc to 2.3pc, compared with an expectation in the markets of something like 2.1pc. It now looks as though by January inflation may be about 3pc.
Government borrowing in October came in above expectations, at the second highest October figure ever. And this followed the news the previous week that the growth rate of GDP in the third quarter was only 0.1pc.
Even major changes in gilt yields may have little effect on the fundamentals of the government’s finances when debt levels are low. But that clearly is not the case today. However you measure it, public debt stands at a dangerously high level. On the net debt measure it is about 100pc of GDP. Debt interest already accounts for over 8pc of government spending, amounting to 3.7pc of GDP.
Unlike many countries in the world, the UK does not pose a default risk for investors who hold its government bonds. After all, the UK borrows in its own currency and it controls the issue of that currency. In extremis, it can get the Bank of England to buy more government debt.
Of course, this isn’t painless. The UK can still effectively default by the back door by eroding the real value of bonds through inflation. This was the story of most of the early post-war period.
The interplay between borrowing, debt and bond yields can become really dangerous. There have been various attempts to quantify the precise point at which the ratio of government debt to GDP becomes dangerous. In fact, there is no magic number.
But if the interest rate on bonds exceeds the nominal growth of GDP (which equals the real growth rate plus the inflation rate), then even if the budget is balanced, the ratio of debt to GDP will keep rising. In these circumstances, it will require a surplus on the Government’s budget (excluding interest payments) to stop the debt ratio from rising.
The higher the debt ratio, the greater the required surplus. In really adverse circumstances, the relationship becomes explosive. That is when default looms. France and Italy are already in a perilous situation. And, of course, they cannot borrow in a currency that they themselves issue.
As it happens, the gilt market took last week’s poor economic data in its stride. Most bond market participants still expect inflation to be subdued and for Bank Rate to come down to about 4pc by the end of next year. It is still possible that gilt yields will drift slightly lower over the next year.
But the Government should not be complacent. The gilt market poses a continuing threat to the public finances. Caution should be the watchword. There is no scope for fiscal largesse or more inflationary pay awards.
Roger Bootle is senior independent adviser to Capital Economics and a senior fellow at Policy Exchange. roger.bootle@capitaleconomics.com