My starting point is
not what Andy
Burnham said but points recently made by Chris Dillow.
Here
he argues that we shouldn’t worry about the bond
market per se, because that market is just an early warning system
for future problems that any government should be worring about anyway. In
that sense, the bond market is no different from, and less important than, an OBR forecast.
For example, if the
government were to start borrowing more to increase public spending,
interest rates in the bond market might well rise, but this is only
because additional public spending would generally increase the
demand for resources, putting upward pressure on inflation. The
government should worry about raising inflation, not the bond market
anticipating this.
I think this
argument is basically correct, but it needs a bit of elaboration. In
particular, while arbitrage means the bond market is generally a
predictor of future inflationary pressure, there are circumstances in
which other factors might influence interest rates because arbitrage
breaks down, as it threatened to do when the pandemic hit, or after
the Truss fiscal event. In this post I will explore those
possibilities, and suggest once again the government has little to
worry about as long as the central bank is doing its job. In addition
I want to explain why these basic truths are hardly ever acknowledged
in the media, because acting as if the bond market is a vengeful god
is just too attractive for most journalists.
Bond rates are
interest rates on long term assets, so they depend on what investors
think future interest rates on shorter term assets will be. If the
two get out of line then there is an expected profit opportunity, and
arbitrage is the process which drives those opportunities to
virtually zero. As short term interest rates are set by the central
bank, then the main influence on bond market rates are expectations
about what the central bank will do in the future, which in turn
primarily depends on what inflation will do in the future.
Any price that
depends so heavily on expectations is likely to be quite volatile.
This volatility is a gift to political journalists. If some political
event happens, then there is a good chance that bond market rates
will have subsequently risen, so they can write a story about that
political event spooking the markets. That may be fair enough if that political event
increases the chance that future inflationary pressure, but equally the movement in rates could be
about something completely different. As Dominic
Caddick notes, there were plenty of headlines about a
‘Burnham premium’ when rates rose in the early days of the
Makerfield election, but no headlines when rates subsequently fell even though expectations he would win increased over time.
Remember that most of the time no one actually knows why market rates
move on a day to day basis.
Politicians and the
public can safely ignore modest short term volatility in bond market
interest rates. If more sustained increases in rates are due to
growing expected future inflationary pressure then they should worry,
but not because of what the markets are doing. They should worry
because inflationary pressure is a problem in itself. Even if the
central bank manages to suppress that pressure by raising interest
rates, in normal circumstances higher interest rates discourage
private investment and therefore longer term economic growth.
Doesn’t the link
between bond market rates and the cost of borrowing mean that
governments should worry about the markets whatever the reason that
rates are moving? No, because the interest rate the government pays on much of its debt is fixed at the time the debt is issued, so rising rates only affect the much smaller amount of new borrowing. As a result the only reason governments
should take note of the bond markets is if the markets are making
intelligent guesses about future inflationary pressure.
A consequence of
arbitrage is that the supply and demand for government debt is
irrelevant to what the current market interest rate on government
debt is, or more accurately demand for debt will adjust to ensure
arbitrage holds. That in turn means that the budget deficit, which is
a key determinant of the supply of new government bonds, is also
irrelevant. Government deficits were highest after the Global
Financial Crisis and interest rates steadily fell. Now of course
current and future deficits, if they reflect additional government
spending or cuts in tax rates, may indicate higher future
inflationary pressure, so in those circumstances journalists are only half wrong if they write
that higher deficits are increasing bond rates. But if deficits are rising because the economy is weakening
then higher deficits will not raise bond market rates.
What is never the
case for an economy like the UK is that interest rate movements
reflect worries about government default. A country with its own
central bank that borrows in its own currency cannot be forced to
default by the markets, and debt would have to be orders of magnitude above current levels before any rational advanced economy government
actually chose to default.
Arbitrage works most
of the time, but sometimes it doesn’t, and those sometimes are the
times we may well remember. Two related things can interfere with
arbitrage: uncertainty and thin markets. If uncertainty about future
short term interest rates increase, then the risk of holding long
term government debt increases relative to holding shorter term
assets, which means that investors will require a risk premium to
hold longer term assets like government debt, and in extremis may
decide to withdraw from the market altogether.
This is what
happened during the onset of the pandemic in Spring 2020, when the
markets stopped buying the debt of most governments completely. In
its place central banks bought government debt instead (Quantitative
Easing). With a recession likely, the last thing inflation targeting
central banks wanted was surging longer term interest rates.
Sometimes, however, uncertainty can be increased by government
actions or inaction, and the central bank may be understandably
reluctant to shield the government from the consequences of its own
actions. That was a key factor in what happened after the Truss
fiscal event, but before looking at that we also need to talk about
thin markets.
Arbitrage works when
there are lots and lots of potential buyers of government debt, so
demand for debt can rise and fall depending on what the profit
opportunities are. But occasionally that isn’t the case for UK
government debt. These occasions are most likely to occur at times of
high uncertainty, when lots of po…
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