Well, the action seems to be hotting up. The story so far: long term bond rates of the UK and US have become closely related, and guess which one is the tail (UK) and which one the dog (the US). Both long term rates have recently been hovering over the German rate which is around 0.5-1% lower. Currently, the UK/US 10 year yields are near identical at around 2.75%, whilst the German rate is a little under 2%. The trend is upwards: in early May (before Bernake’s “Tapering” announcement to Congress), the same rates were US/UK 1.6% and Germany 1.3%. Hence we have a simple story. Germany can be seen as the reference point. The US and UK have higher rates, reflecting “inflation risk”. With all of the QE going on markets believe that there is clearly much more of a risk of inflation over the next decade. Also, the Germans seem to be keeping as hard a grip as possible on the expansionist tendencies of super Mario at the ECB. France also has higher long rates than Germany: this could stem from a combination of “Euro break-up” risk (any post-breakup French currency would devalue against the new DM) with default risk.
Now, back to Bernanke on the 22nd May announcing the possibility of tapering commencing soon: well now in fact. QE, which has meant the Fed buying up lots of the US national debt has kept US government bond prices high, and hence the long rate low. Stopping buying up government bonds can have only one effect: bond prices fall, and long term interest rates rise. But, of course, the markets are forward looking. If prices are going to fall in a few months, people will start to change their positions and hold less of the bonds, leading to rise in interest rates well before any tapering has actually happened. The BBC has been following this, particularly in relation to the effect on emerging markets. The prospect of rising US interest rates has led to money flowing out of emerging markets, reversing the flow caused by QE pushing investors onto emerging markets in search of “higher yield”.
But of course, the effect will not just be on emerging markets. If we leave aside the Eurozone for the moment, which has its own special dynamic, the UK will be affected by this too. Enter Mark Carney, with his forward guidance in July. No tapering in prospect, with long-term interest rates to be kept low if necessary with more QE (oh, with a long list of conditions of course, but let’s stick to the main story). Well, is it possible for the UK to have substantially lower interest rates than the US? Well, of course it is possible: however, it will have consequences. Let’s see how the markets reacted. After the Forward Guidance, markets seemed to give Mr Carney some credibility: UK 10 year rates fell below US rates, about 20 basis points and remained below until late August. Now they are back together. Well, markets realised that the Bank of England will not be able to have lower rates than the US for long. The consequences would be a devaluation of sterling, which would almost certainly lead to more inflation. The recent experience of Sterling’s devaluation against the Dollar would indicate that a large part of it would pass through into inflation over 2-3 years. Since inflation is currently well above target, devaluation would be most unwelcome. And of course, one of Carney’s caveats referred to interest rates having to respond if inflation became too high.
So, what is the take home for economists? Well, the most unnatural state of affairs with low interest rates is a bit of a Prisoner’s dilemma. Most of the developed world needs to follow the policy of “repressed inflation” , the key feature being sustained negative real interest rates to help with public finances and reduce the growth in debt-GDP ratios. However, as in the Prisoner’s dilemma, they can only do this if they stick together. If one of the main players (The US, the ECB, BOJ, maybe even plucky little BoE) decides to break and offer higher interest rates, funds will flow to it. In order to keep savers and investors in thrall to negative real returns, they need to have no safe alternative. Emerging markets may look attractive but are subject to lots of “other” risk (politics, potential crises etc.). If the US is going to offer more attractive interest rates, it will be hard for the Bank of England to persuade investors to buy British bonds. Of course, a devaluation against the Dollar might be attractive for some countries: Japan for one might be quite happy as this will help them generate some of the inflation they want to create. But not the UK. Forget forward guidance? Maybe the markets already have. Or maybe Mark Carney has something up his sleeve….let’s see how this continues to evolve over the coming months as tapering (probably) becomes a reality…Isn’t economics exciting: you never know quite what is going to happen next…