Why worry about the US bond market?
If you're not an economist or a bond trader, you might wonder why there should be such a fuss about roughly half a percentage point rise in the interest rates on US 10-year government debt.
It's a reasonable enough question. There are quite a lot of things that matter to people in the markets which need not concern the rest of us at all.
Unfortunately, the recent change in US long-term interest rates is not one of those things. It potentially matters quite a lot to the future of the global economy.
The problem is we can't say, yet, whether it's good news or bad.
Remember what a government bond yield is. In effect, it's the interest rate a government implicitly agrees to pay when it borrows money from the financial markets.
When investors don't want to lend to the government, that government's bonds (IOUs) are worth less - and the implied interest rate (yield) has to be relatively high.
Conversely, when investors are keen to lend the value of the debt goes up, and the government doesn't have to pay so much interest. So a rising bond market spells falling rates - and a falling (bear) market in bonds spells the opposite.
So much for the introductions. What's all the fuss about right now?
The fuss is about the fact that Uncle Sam had to pay 2.1% at the end of May to borrow money for 10 years - up from about 1.65% a month before.
Logically, there might be at least four potential explanations for this:
- Investors might think the US government is a riskier bet than it was in April.
- They might think inflation is going to be higher than they thought then.
- They might be looking at more alternative homes for their money in the private sector, because growth and confidence in the broader economy is picking up.
- Or, finally, investors might be dumping bonds because they're worried the central bank is going to stop creating money under quantitative easing and raise short-term interest rates sooner than expected - meaning long-term rates are going to rise (and bond prices are going to fall), and the people who bought at low rates are going to lose out.
It's not reason one: if anything, America's public finances look stronger now than they did a few months ago, with the deficit numbers coming in much lower than expected.
It doesn't appear to be reason number two, either: if you look at the difference between regular government bonds and ones that are indexed against inflation, inflation expectations haven't risen in the past few months, they've actually gone down. So, in the economics language, this is a rise in real rates - not just nominal ones.
That leaves reason three or four.
As you will have spotted, these are not mutually exclusive: if there's a faster-than-expected economic recovery in the US creating more private investment opportunities, you might expect the central bank to bring forward the time that it reins back its extraordinary support for the recovery as well.
However, it matters quite a lot that the recovery in confidence and private investment comes before the change in expectations about the central bank.
Heading back to normal?
Hard to imagine now, but there was a time when even very prudent governments had to pay a real interest rate, after inflation, of at least 2 or 3%. That is about the long-term average and it's perfectly healthy.
Today the US is paying a real interest rate of less than half a percentage point. In the UK, the government's cost of borrowing is probably negative, after inflation.
In other words, investors are basically paying the government to take money off their hands. That tells us the world is still a scary place and the global economy is still severely impaired.
Many worry, with some justification, that very low rates and efforts to pump money into the economy are producing a bubble in certain types of assets and distorting financial decisions.
How do you measure the potential return from a private investment against the "risk-free" rate on government bonds, when that rate is essentially being rigged by the central banks?
So, it would be healthy for the economy if the recent rise in US (and British) bond yields told us we were heading back to something more normal.
But, like most things we want to happen in the financial markets, we don't want it to happen quickly.
There's so much money now sloshing around the global economy, a dramatic shift out of bonds into other kinds of investments could be hugely destabilising. And a sudden rise in borrowing costs for businesses and households risks snuffing out the recovery.
To state the obvious, the US central bank has an enormously tricky line to walk here. It wants to signal that low rates will not be here forever. But it cannot afford to set off a stampede out of the bond market while the major advanced economies are still so weak.
The Federal Reserve managed this transition successfully in the mid-noughties, when it started to raise rates from 2003 onwards and long-term interest rates only slowly edged up. By contrast, 1994 was a rout, with long-term rates rising nearly 2 percentage points in less than a year.
For all the jitters in stock markets, most economists seem to think we're looking at the "right" kind of rise in long-term rates - one driven by rising optimism about the real economy not just rising nervousness about the Fed and its plans.
They may be right. But it's worth remembering that the sharpest rise in rates, in the past few weeks, came not in response to any news about the US recovery - it came in response to some apparently throwaway remarks by the Federal Reserve chairman.
There will be more bumps in the road, but this transition to a more normal world is likely to go better, the more that investors take their cues from the real economy, not Ben Bernanke.