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Who’s afraid of the gilt market?

The writer is a former global head of asset allocation at a fund manager

Governments have been in thrall to bond markets for centuries. But the term “bond vigilante” was coined just 40 years ago when the economist and Wall Street analyst Ed Yardeni argued that if policymakers failed to regulate the US economy, bond investors would step in.

Last September saw UK government bond investors not so much stepping in as freaking out. But this is semantics. The results — the reversal of heterodox policy measures and resignation of Liz Truss as prime minister — were cast as offerings to bond vigilantism.

This week, UK government bond yields breached the levels that caused last year’s financial mayhem. But, unlike autumn 2022, there has been a notable absence of market panic. Fund managers have been falling over themselves to declare gilts attractive. And instead of requiring a Bank of England intervention to save them, defined benefit pension schemes are in record surplus.

What has changed? Today higher bond yields are a feature of policy. Last time they were a bug.

The current bout of bond price weakness can be seen as investors repricing their best guesses around the likely path of BoE interest rates in the context of the data. Price inflation in the UK has been stubbornly sticky and the labour market persistently strong. As a consequence, the central bank looks likely to raise rates higher than previously thought and keep them higher for longer. September’s collapse, by contrast, saw then Chancellor Kwasi Kwarteng’s lurch into policy heterodoxy accidentally tripping a set of leveraged positions that set off a “run dynamic” in the gilt market.

Higher yields come with a cost, regardless of how they are arrived at.

There are over 400,000 UK mortgage holders rolling their fixed-term mortgages each quarter this year, mostly from deals with rates below 2.5 per cent. The effects of higher bond yields on those in line to refinance will range from merely costly to personally ruinous.

Costs are felt by the government too. As the issuer of its own currency, the financing constraints faced by the UK government are different to those faced by households. To ensure public finances are managed to avoid the risk of default or inflation, Britain — like most countries — operates a series of fiscal rules. Their latest incarnation centres on reducing public sector net debt and balancing the budget in the third year of a five-year horizon.

Despite the rise in bond yields, it shouldn’t be hard to meet the debt target in the short run. Only a portion of government debt is inflation-linked, while government revenue and gross domestic product are overwhelmingly so. This means that debt is in the process of being inflated away.

And despite a high debt stock, interest costs as a percentage of GDP remain low, putting little pressure on the budget. This is in part due to the effect of having locked in so much long-term debt at low yields. This is not a bad place to be.

As a rule of thumb, government debt interest costs have typically needed to reach 5 per cent of GDP before they are met with real alarm in finance ministries, with fiscal adjustment programmes tending to follow. We saw this in Canada in the mid-1980s and again in the mid-90s, in Italy’s 1988 and 1995 plans, as well as the UK’s 1976 IMF programme and 1980 “medium term financial strategy”. We are still some way from these levels, although the longer yields stay elevated, the greater the debt service cost pressure will grow on the broader budget.

The gilt market is increasingly important to our lives. As Truss demonstrated, ignoring it can be costly. But listening too much to the bondholder lobby, whose financial interests are maximised when economic growth is absent and disinflation rife, also carries costs. Fear of bond market monsters is a bad reason to delay investment in vital infrastructure or the green transition.

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