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Developed world government bonds are the most boring asset class out there.
If you lend your money to a typical developed world government with its own currency, you expect to get it back.
This is why the yield on these bonds is sometimes referred to as a “risk-free” rate – it’s the return you can expect for taking the least risk possible.
That’s also why they’re boring.
But they’re also very important.
So let’s see why they’ve been creeping into the news this week.
British government bond yields are rising – but it’s not just about Brexit
Gilt yields (the interest rate on UK government debt) are grabbing a few minor headlines in the Financial Times this morning, I noticed. They rose steadily last week. At the start of the week, it cost the UK government around 1.15% a year to borrow money for ten years. By the end of the week, that had risen to 1.30%.
That doesn’t sound like a big change – and it’s certainly nothing spectacular – but in the stolid world of government debt, it’s at least notable.
When gilt yields rise, prices fall (and vice versa). So it means that demand for gilts has gone down. Why would that be? In this case, it means that investors think that interest rates (as set by the Bank of England) are likely to go up earlier than perhaps they had expected at the start of the week.
And why would that be? What it boils down to, as we’ve noted here several times before, is that markets increasingly think that Britain’s exit from the EU is likely to come in the form of Theresa May’s deal (which they are now used to), if it happens at all. It may also be delayed for some time.
If Brexit is “soft”, indefinitely delayed, or cancelled, then there’s no threat to the UK economy – or at least, the threat is a quantifiable one. In turn, that suggests that the Bank of England will end up having to raise interest rates at least a bit from where they currently are.
And when interest rates or inflation rise, you don’t want to be hanging on to fixed-income debt like gilts. If your gilt is paying you £1 for every £100 you invested, while your bank account is paying you £2, you’re on to a loser. No one will buy that gilt off you for £100.
So that’s where we are. Gilt yields have gone up because markets now think that a “hard” Brexit is less likely.
By the way, this is a healthy sign. If gilt yields go down, it shows that UK government debt is in demand. So the fact that gilt yields fall when investors think a “no deal/cliff edge/clean” (delete according to political persuasion) Brexit is on the cards, is a sign that they still regard gilts as a safe haven, even outside the EU.
What would be concerning is if yields rose – ie, investors were dumping gilts – as a “no deal” Brexit became more likely. That would show that investors were genuinely fearful of owning any British assets at all and would raise the risk of a surge in interest rates.
Instead, people want to hold more government debt, even as an outcome that they fear becomes more likely. Investors might not be keen on Brexit. But they also don’t expect it will result in the UK shrivelling up like the villain in a Hammer horror film and sinking into the depths of the North Sea. Which is the impression you might get from some commentators.
So there we go. It’s all about Brexit.
Well, actually, it’s not. It’s easy to miss the fact that this is not restricted to UK government debt.
Why take more risk than you need to?
Government debt across the globe declined in value last week (and so yields rose). As with gilts, the rise in yields was not spectacular. Indeed, the yield on Japanese ten-year government debt is just a hair’s breadth above zero right now. That said, it was sitting at minus 0.04% earlier last week.
The same goes for German government debt (which in effect, represents the “risk-free” rate for the eurozone). German government bond yields had been sliding towards 0% for most of this year. But last week they got a bit of a reprieve.
And then of course, there’s the all-important US Treasury (government debt) yield – the “risk-free” rate for the entire world.
The yield on ten-year US government debt crept up last week, towards 2.75%. That’s still a long way off the 3.26% it peaked at in October last year. But it’s starting to perk up.
The question is why? The answer, as you might have gathered from the Brexit point above, is that rising yields indicate that investors are growing more bullish again.
Note that yields peaked back in early October. That’s also when the stockmarket peaked.
These things feed off each other. If you can get 3.25% from a ten-year US Treasury bond, that’s starting to look appealing. If Treasury yields rise too far and too fast, they effectively suck money out of other markets.
People aren’t stupid. If you offer them a “risk-free” return that looks as though it’s a better bet than the “not remotely risk-free” return on offer from other assets, then they will snap it up.
A couple of things happened in October. First, investors really started to worry about the pace of global growth, and therefore the outlook for “risk” assets. Then they suddenly noticed that they could get a good return on “safe” assets.
Why wouldn’t they make the jump? Look at it this way, and our recent growth scare could equally be categorised as a “too far, too fast” move. Under this scenario, all that happened is that markets got ahead of themselves in terms of optimistic assumptions. They suffered a bout of vertigo as those assumptions started to be questioned.
But it’s also very easy for such a reversal to go too far. My gut feeling remains that this is what happened, and that this rebound in bond yields is a sign that markets are changing their minds again.
We can only keep an eye on what happens and keep updating our scenarios as we get more information coming in. But for now, I think fear of recession is overdone.
(And for more on why US government debt may not always be the “risk-free” rate at all, you should read my cover story in the latest issue of MoneyWeek magazine – subscribe now to get your first six issues free).