Bond investors pay price for governments' success in cutting national debts

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The Independent Online

The financial markets should in theory be delighted by shrinking government budgets. Unfortunately, the decline in borrowing requirements has led to the supply of new bonds drying up, forcing returns to investors in the US and UK to fall.

The financial markets should in theory be delighted by shrinking government budgets. Unfortunately, the decline in borrowing requirements has led to the supply of new bonds drying up, forcing returns to investors in the US and UK to fall.

Who can ever forget James Carville, Bill Clinton's wise-cracking campaign manager in the 1992 election, declaring that if he were reincarnated he'd come back as something really powerful like the bond market? The candidate's spending policies were constrained by the need to balance the books, yet this fiscal orthodoxy was repaid by an economic boom as long-term interest rates moved lower.

Yet President Clinton caused market turmoil earlier this month when he declared the US national debt would be paid off by 2013. The accompanying statement from the US Treasury that it would buy back long-dated Treasury bonds caused their yields to lurch down below those on shorter-dated government securities. The Treasury market in general has been suffering declining prices and rising yields for a year and a half, but market participants were alarmed at the prospect of a chronic shortage of the longest-term bonds for them to buy.

Traders in the US bond market described the conditions as the worst since the crisis caused by the collapse of Long Term Capital Management in late-1998. Hedge funds and investment banks were reported to have suffered big losses as the prices of very long-term Treasury bonds jumped and yields fell, taken unawares by the speed at which the Government's debt would shrink, and by the Treasury's focus on redeeming the longest-term bonds.

The resulting "inversion" of the yield curve - whereby 30-year bond yields fell below those on 2- and 5-year securities - was familiar to investors in UK gilts. On this side of the Atlantic the cross-over occurred in 1997. Shrinking supply due to a declining government deficit and ultimately a shrinking level of debt was one part of the explanation.

But the situation in the UK has been aggravated by the Minimum Funding Requirement on pension funds. A regulatory legacy of the Maxwell affair, this has forced all funds to buy a far greater amount of long-term bonds than they did a decade ago.

What's more, the UK, unlike the United States and continental Europe, has no alternatives to government bonds. Issuance in the corporate bond market exploded last year but remains far too small to satisfy the demand for ultra-secure long-term investments. Nor does the UK have quasi-governmental issues like the mortgage-backed securities available elsewhere.

The inverted yield curve means pensioners are getting less from the annuities bought by their funds at retirement - or alternatively that the funds are having to pay more to provide annuity rates guaranteed when the general level of interest rates was much higher.

The Debt Management Office's funding policy has exacerbated the shortage of supply of long-term bonds. The latest funding remit showed more sensitivity to the needs of institutional investors, emphasising there would be a bias towards issuing long-term stocks. But some experts argue that the Treasury should make it crystal clear it will issue long rather than short-term gilts.

"We have a regulatory structure that makes people borrow money when they are young at the maturities where interest rates are at a peak, and yet in their retirement makes them rely on the lowest yields," said Steven Bell, chief economist at Deutsche Asset Management. He said: "The Treasury should issue only long-term gilts, because that is also the cheapest way for the government to borrow money."

Economists point out that the classic operation of demand and supply forces in two major bond markets - sending prices up and yields down - is also making it harder for the central banks to run monetary policy at a time when interest rates need to rise to cool down the economy on either side of the Atlantic.

Mark Cliffe, chief economist at ING Barings, said Alan Greenspan has a knotty problem. "He will not only have to wrestle with divergent signals from the economy but near-chaotic scenes in the financial markets."

He predicted the Fed chairman would be careful not to disrupt the financial markets any further, and signal only a small increase in interest rates to come. "Given the current skittish mood in the markets, he may decide that the prudent course is to imply that the Fed intends to do no more than validate the market expectations."

In the past, inverted yield curves have been a harbinger of recession, signalling the expectation of forthcoming increases in short-term interest rates to cool off the economy, without a deterioration in the long-term inflationary outlook. But few analysts think this is the case now.

George Magnus of Warburg Dillon Read said the recent developments indicate the US long bond, once the benchmark for term world interest rates, is now a "museum piece". He said: "The curve shape has been influenced mostly by dwindling supply expectations."

In other words, now that the US and UK governments have stopped spending far beyond their means, they have cut off the fuel to the once-mighty bond markets. If James Carville were to make a comeback for this year's election campaign, he would not choose the bond market as the symbol of financial power.