Will bond yields kill recovery?

A striking feature of the Clinton presidency is the central role it gives to the bond market. Not the dollar, not the stock market, not the oil market but the boring old bond market. The long bond yield, it seems, mesmerises the White House like no other statistic, apart perhaps from the president's opinion poll approval rating.

For an administration which used up so much of its initial political capital to control the budget deficit, and in a nation where taxi drivers seem habitually to invest in fixed income mutual funds, this fascination with bonds is perhaps understandable.

In Britain, it would be an exaggeration to say that the gilt market plays such a central role in political life. I cannot remember if I have ever seen the long gilt yield making an appearance on the Nine O'Clock News, although the level of share prices is quoted most nights. But now the recent horrible performance of the gilt market is becoming a cause for political concern.

The yield on 10-year gilts has risen from a low point of 6.1 per cent on 29 December to 8.7 per cent now. If this persists indefinitely, it will eventually increase the Government's annual bill for debt service by pounds 6bn, enough to finance a 4p cut in the basic rate of income tax, or a 20 per cent rise in spending on the health service. These are not small potatoes.

Furthermore, the recent penchant of the bond market to push up interest rates across the yield spectrum, even though the Bank of England apparently has no desire yet to raise base rates, is imposing on the economy a tightening in monetary conditions which the authorities cannot control.

Earlier this year, most mortgage customers were taking out new loans at fixed rates of around 7 per cent. Now, new customers are paying at least 8.5 per cent for fixed-rate loans, which is one important reason why the housing market appears to have gone back into the doldrums since the spring. Although the main effect here was probably on the timing of transactions as people rushed to beat the possible rise in fixed rates, it was nevertheless important.

EXPECTATION GAP

Both the Chancellor and the Governor of the Bank of England have claimed in recent speeches that this rise in yields is a severe over-reaction, but this has not yet steadied the market's nerves. To a large extent, the performance of gilts has mirrored that of other global bond markets in direction, although it has been worse in degree. In fact, all around the world, there is a huge gap between what the markets expect the central banks to do to short rates in the next few quarters (very pessimistic), and what the central bankers themselves expect to do (quite optimistic). The extent of this gap is highly unusual.

Central banks throughout Europe are becoming quite concerned about what the rise in long yields is doing to the prospects of economic recovery. Without exception, short- term interest rates - the equivalent of UK base rates - have been reduced this year to stimulate economic activity, but long-term rates have risen. As a consequence, the yield curve - the ratio of long rates to short rates - has steepened dramatically.

The table shows the change in short and long rates in the main economies since the beginning of the year. It also shows a weighted average of the change in these yields, using the share of short and long-term debt in each of the economies to determine the weights. In Germany, for example, about 75 per cent of outstanding debt is at fixed long-term rates, while in the UK the proportion is only about 20 per cent. As a result, the vulnerability of each of the economies to a rise in long yields is very different, but in no case is it small enough to be ignored.

If this rise in long yields persists, then it will eventually represent a significant tightening in monetary conditions. Furthermore, as we have seen from the example of UK fixed-rate mortgages mentioned earlier, changes in long-term rates can have important effects on the housing and other markets by changing the timing of transactions. It would, however, be wrong to exaggerate the effects of higher bond yields on the European recovery. There are three reasons for this.

First, it obviously takes quite a while for long-term contracts to unwind and, until they do, there is little effect from higher yields. Although the table shows what will happen to average debt servicing costs in each economy when all fixed income contracts have been renegotiated, it will in fact take many years for all long-term contracts to come up for renewal. Consequently, over most relevant time periods, the change in short rates is almost certainly more relevant than the average rate changes shown in the table.

Second, even when outstanding debt has expired, it is possible for erstwhile long-term borrowers to refinance their debt at the shorter end of the market. So there is always an escape route from the tyranny of higher bond yields, although it means incurring greater risk through issuing floating-rate debt.

Third, there is the question of why long bond yields have risen in the first place. If they have risen because of a change in the mood of the financial markets, or because the central banks are expected to raise short rates at some point in the future, then it is reasonable to see this as a tightening in monetary conditions which could eventually restrain economic activity.

An alternative explanation for the rise in yields, however, is that it is reflecting a pick-up in private investment spending, or higher budget deficits, both of which will boost economic activity.

In theory, real long-term bond yields will move up and down to bring savings and investment flows into equilibrium in the capital markets of the world. If there is a spontaneous rise in global investment, the real bond yield should rise in order to generate the savings flows which are needed to finance the extra capital spending. When this force is at work, a rise in bond yields is a signal of future increases in activity and is not something to be worried about.

EFFECT ON EQUITIES

There is one other factor to mention, and that is the effect of higher bond yields on equity markets. European share prices are now about one-fifth below the peak levels reached earlier this year, and this decline will obviously affect household wealth and, to some extent, business confidence.

The decline in equity markets, however, has not so far fully offset the rise that the same markets enjoyed in 1993, and that rise had not been fully absorbed into spending behaviour by the time the recent decline began. Unless the weakness in equities turns into a more precipitous rout, it seems very dubious whether it will dent demand growth very much.

I am therefore broadly reassured that the widening economic recovery in both the UK and Continental Europe will prove sufficiently robust to survive the present bond market malaise.

(Table omitted)