Chris Johns: Worry more about bonds than Brexit
It is bond markets which determine what central banks can do
Bond yields play a significant role in where stock markets go and in the determination of house prices. Photograph: Getty Images
Why are interest rates so low? A lot depends on the answer. Only when we understand the drivers of today’s ultra-low rates will we get a handle on when the European interest rate cycle will turn. That’s a big deal for anyone with a mortgage or a car loan.
Interest rates have started to go up in some places. In the US, Canada and the UK it looks like the cycle has turned, and next year could see more rate hikes in all three countries. But it will be a huge surprise – a shock – if European interest rates rise in 2018.
It is sometimes right to expect the unexpected. In that vein, the actions of the European Central Bank (ECB) next year should hold our attention. If those English-speaking countries are right to be tightening monetary policy, an ECB rate rise can’t be too far behind. And mortgage rates will inevitably follow.
In the US the Fed has tightened policy at a time when there is little inflation and no sign of the fully-employed economy generating any wage pressures. Critics say the Fed is unnecessarily taking risks with economy: wait, instead, until wage inflation shows signs of picking up.
There are all kinds of interest rates and all of them, like wages, pose a puzzle. They are lower than is usual at this point in the cycle.
Bond yields – long-term interest rates – are said to be the most important variable in finance. It is these rates that ultimately determine the cost of our mortgages, whether companies can afford to invest, and how much of our taxes are spent on government debt interest. Low yields have helped drive many pension schemes into deficit.
Bond yields play a significant role in where stock markets go and in the determination of house prices. Bonds played a massive role during our own financial crisis: remember “burn the bondholders”.
Central banks can fiddle with short-term interest rates, but they can’t do much, except perhaps in the short term, about bond yields. And, ultimately, bond markets determine what central banks can do, not the other way around. Bond yields receive less attention but are more important than Brexit.
As with interest rates, bond yields look ridiculously low. Many governments can borrow at zero or negative yields – investors are happy to accept a guaranteed loss. It’s weird, but it has been going on for so long we are now used to it.
Read anything from the greatest minds of Wall Street or the City of London and you will hear worries about a “bond bubble”. The price of bonds – whether issued by governments or business – is way too high. Paying the government to borrow your cash just seems nuts.
The list of suspected drivers of low long-term interest rates is both long and contentious. One possibility is that there isn’t any need to borrow so much for investment these days because a business is more likely to write a few more lines of code than build a factory.
In a recent article a Bank of England economist suggested that the fall in bond yields has not been such a recent phenomenon as is commonly assumed. Yields have been dropping since the 13th century, he said. The Bank of England author didn’t say this but one conclusion is that something that has been going on for so long might not be so crazy after all.
Why should government bonds yield anything at all? Countries like the US and UK will never default on their loans – they can, in extremis, just print the money to repay the debt. But that will just raise inflation, so bonds should, it is argued, pay an investor compensation for the risk of inflation.
But remember there is no inflation right now, little prospect of any, and governments have just printed trillions of new currency without any effect on prices at all.
The other main reason why bonds should pay interest is that investors need to be paid for their patience. In the jargon it is the “time preference of money”: compensation for waiting a while to spend today’s hard-earned cash.
But there are plenty of financial institutions, like pension funds and insurance companies, that have been forced by regulators to prefer the certainty of future cash. For these firms, thanks to legal requirements, a bird in the bush is worth much more than one in the hand. They have to buy bonds, whatever the price, even if it means losing money.
This might be one of those “it’s different this time” arguments. Bond yields may be in a bubble. But people have been making this bet against Japanese bonds for at least two decades now. That trade, for good reason, is called the widow-maker in financial markets.
If bonds are in a bubble it will be in its bursting that we will see the start of the next financial crisis.
If, alternatively, bond yields have reached their final resting place after 800 years of travel then mortgage holders can rest easy, the world economy will continue to grow, and stock markets may continue to occupy dizzying heights. Worry more about bonds than Brexit.