The bond market: not that scary

The Duncan Weldon Economics Matters Column

In the early 1990s, Clinton advisor James Carville said:

“I used to think if there was reincarnation, I wanted to come back as the President or the Pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody.”

Was Carville right? Is the bond market, the market through which the government funds its deficit, still intimidating? George Osborne certainly seems to think so.

Government borrowing this year is expected to be around £175bn – a record amount both in absolute terms and as a percentage of GDP. That isn’t really very surprising. The UK is experiencing the longest slump in decades and so tax revenue is falling and spending on benefits rising. To a greater or lesser degree, every major economy is facing large fiscal deficits.

We have heard a lot of noise from the Tories on the issue of ‘foreign investors losing confidence’, about the idea that this borrowing is ‘unsustainable’ and from the ratings agencies on the outlook for the UK. Before considering these claims it is worth reminding ourselves how the government goes about funding deficits.

Obviously, every pound that the government spends that is not raised from taxation has to come from somewhere. The government borrows this money from investors (pension funds, insurance companies, banks and foreign institutions) through issuing gilts (as UK government bonds are known). Gilts are issued at various maturities (one year, five years, ten years, etc) and with a fixed interest rate called the coupon (so-called as once upon a time gilts were issued as bits of paper with coupons on the side that were cut off and handed in, in return for the annual interest payment).

So for example, if the government issued a 10 year £100 gilt with a £5 coupon, then the buyer would be entitled to £5 every year for ten years and then £100 at the end when the gilt was redeemed. The gilt would be issued ‘at par’ with a price of £100. Over the life of the bond the price might rise or fall depending on a whole host of factors – the likely outlook for interest rates, the prospects of future inflation, the attractiveness of alternative assets, the credit worthiness of the government, etc. As the coupon is fixed at £5, changes in the price of the gilt effect the interest rate received by any buyer. So, keeping the example very simple (and ignoring the concept of redemption yield which slightly alters the maths but doesn’t change the picture), if the price of the gilt fell to £50 the interest rate it carried would now be 10% (£50 price and £5 coupon). If the price rose to £200 the interest rate would fall to 2.5% (£200 price and £5 coupon). The key point to grasp here is that however the underlying gilt price varies after issue, the interest bill faced by the issuer (the government) is fixed at sale (£5 annually in this example).

This year the government is selling £175bn of gilts at various maturities. That’s a big number. The Carville quote which opened this piece refers to the power of so-called ‘bond market vigilantes’. It was once thought that the bond market was almost all powerful. By refusing to purchase government bonds at low prices, and by demanding high interest rates, bond market vigilantes could exert a huge influence over government fiscal policy.

When Osborne scaremongers over the deficit, this is generally what he is talking about – the notion that the bond market might collectively take fright at the scale of UK borrowing and refuse to buy the UK’s gilts at decent prices. This would cause the interest rate on gilts to rise which would mean more and more of the UK’s tax revenues simply went on paying interests. In effect, the markets could force the government to raise taxes or cut spending by refusing to lend.

There is an easy way to check of Osborne is right to worry or if he is simply talking nonsense and using spurious financial logic to justify an ideological position: simply look at the interest rate on a 10 year government gilt. If the markets are worried then it will be high and rising, if they are not then it will be low.

Today the interest rate on a 10 year gilt is 3.77%. That meant the bond market, the stuff of James Carville’s nightmares, is prepared to lend to the UK government for ten years for less than 4%. Hardly terrifying. In the early 1990s the gilt yield was well above 10%!

The policy of quantitative easing (the Bank of England buying gilts) has probably artificially lowered that yield somewhat. Most independent estimates (by firms engaged in buying and selling points) reckon that it has reduced yields by 0.5%. So, for the sake of Mr Osborne, let’s assume the yield is actually closer to 4.25% in the absence of QE. Again, hardly terrifying.

If people are really interested in the markets’ views of the UK, they could do worse than simply checking the 10 year gilt yield each day. If it starts to rise and passes 5%, then 6%, etc, then maybe Osborne has a point. Until then though, he can be safely ignored.

(I’ll be away from a computer for most of today so will respond to comments either this evening or tomorrow morning.)