Jeremy Warner: Rising bond yields point the way to economic recovery
Friday 12 June 2009
Outlook Government bond yields around the world are soaring as inflationary expectations rise and debt management agencies struggle to fund record peacetime fiscal deficits. Both in the US and the UK, 10-year yields are back above 4 per cent, a level not seen since October last year. This is a complete reversal of the situation of just three months ago, when to many it looked as if the world was about to be engulfed by deflation and a second Great Depression.
As if to demonstrate that there is always something left to worry about, a new concern has now come to dominate consensus thinking – that rising bond yields threaten to derail the still nascent economic recovery by raising mortgage and corporate lending rates too fast.
The fear is that faced with a buyers' strike and rising inflation, governments will be forced to raise interest rates to such an extent that it kills off all chance of economic revival. What's more, all that government borrowing may end up "crowding out" private credit and therefore prevent a wider economic renaissance.
Obviously these are dangers, but for the time being the better way of looking at rising government bond yields and a weakening dollar is as a positive, rather than a negative development. Far from marking the beginnings of a new crisis, in fact they are only indicative of a return to normality.
Why would I say such a thing? Is this not the end of the dollar hegemony that has for so long been predicted by the likes of Niall Ferguson, the economic historian? Are not rising yields a first sign that the Chinese are turning their backs on satisfying America's insatiable appetite for debt?
No empire lasts for ever and some of them, such as that of the Soviet Union, are dated in merely decades. America's age of geo-political dominance will likewise eventually fade and die, but perhaps not quite yet.
The reality of bond yields on both sides of the Atlantic is that though they have certainly risen to a striking degree – in the US, bond prices have virtually halved within the space of just four months – they remain remarkably low by historic standards.
Given the scale of the funding programme – the US alone is expected to raise more than $3trillion in new borrowings this year – the perhaps more noteworthy thing is quite how low they still are, rather than how high. The same can be said of Britain, where yields remain almost incredibly tame given that the country is about to clock up the largest ever peacetime deficit on record.
As I say, the yields we are seeing today are not so much an aberration as a return to normality. But certainly what's going on is a little counter-intuitive. It also raises questions about the efficacy of the policy response, how much of it is strictly necessary, and whether central banks might be provoked into a rather earlier exit strategy than previously thought.
Some policymakers want to make discussion of exit strategies, or how to withdraw the fiscal and monetary stimulus that has been provided, top of the agenda for this weekend's meeting of G8 finance ministers in Italy. To many this will look somewhat premature, with recovery far from established and unemployment still rising sharply, but certainly things seem to be moving in the right direction.
When the Bank of England announced its programme of Quantitative Easing (QE) a little while back, the idea was that by buying large quantities of gilts with newly minted money the Bank would push down gilt yields thereby persuading investors to chase higher yielding, riskier assets.
This in turn would help to get credit conditions and private sector activity functioning normally again. In fact, gilt yields have risen. What this shows is not that the policy has failed, but that we are arriving at the desired outcome by a rather different route.
One of the main reasons why bond yields are rising and the dollar is weakening is that investors are rediscovering their appetite for risk. Just as gilt yields have risen, corporate bond yields have eased somewhat. Equity prices have also been rising strongly. As investors turn their attention to riskier assets, the dollar, traditionally regarded as a safe haven in times of trouble, has suffered along with US Treasuries. None of this is great news for governments attempting to finance their ever growing debt mountains, but if the ultimate purpose of policy was to encourage investors back into riskier assets then it seems to be succeeding. Or perhaps it is occurring regardless of policy.
In markets, there is never any single explanation for anything. One of the other reasons for rising bond yields and the weakness of the dollar is rising inflationary expectations. This again is a complete reversal of the position that reigned just three months ago, when most were expecting outright price deflation.
Since then, the oil price has come racing back. Particularly in the US, there is a strong correlation between gas prices and people's inflationary expectations. Yet how realistic are these inflationary fears? Around the world, producer prices are still extraordinarily tame and in some countries falling fast. The recession has created massive spare capacity in nearly all economies. The threat of outright deflation may have been seen off, but by the same token it is still quite hard to see a serious inflationary problem re-emerging any time soon.
Rising bond yields may not be welcome to cash-strapped governments, but if all they amount to is more evidence of green shoots, are they really anything to worry about? At this stage, the answer has to be probably not. But Angela Merkel, the German Chancellor, has a point in raising the alarm about loose money. The idea that we could suddenly find ourselves in the midst of an inflationary mini-boom, or that we are only laying the foundations for another credit bubble, is not as far fetched as it might seem.
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