Why the US bond market matters

Felix Martin's "Real Money" column.

On 22 May, Ben Bernanke, the chairman of the board of governors of the US Federal Reserve, made what must have seemed to innocent observers an innocuous remark: he suggested that the era of nearzero interest rates in the US could not last for too much longer and that the Fed might begin to wind down its policy of quantitative easing (QE) later this year.

The reaction of the world’s financial markets was swift and dramatic. First, the interest rate on US government bonds jumped. Then the world’s currency markets went haywire. The US stock market battled on for a few more weeks before it, too, took fright and embarked on a precipitous descent.

People who are not finance professionals might be forgiven for asking what all the fuss is about. Why, after all, should these inconsequential remarks matter so much – and so what if the interest rate on US government bonds rises by a mere 1 per cent? Is any of this relevant to normal people who don’t spend their time buried in the back pages of the Financial Times? The answer, unfortunately, is yes.

The government bond market is the axis on which the financial system of every modern, capitalist economy turns. The interest rate at which the government can borrow is the most important price in the economy – the one on the basis of which the price of every other financial asset and, indirectly, all other prices and wages are set.

Companies and individuals pay interest rates on their borrowing at rates set as a markup over the government’s rate. So if the UK government can borrow for a term of ten years at 2 per cent, then a financially robust and well-established company might be able to borrow at 3.5 per cent; and a flightier, less well-capitalised, more speculative one might be able to borrow at, say, 7 per cent. You or I, meanwhile, might be able to borrow at an even higher rate than that. When the interest rate the government pays moves, so do all the others. Thus, the interest rate on government bonds affects the entire economy.

In this matter, as in so many others, the US is more important than every other country. It is not just that the interest rate on US government bonds is the reference point for the largest economy in the world. The US dollar is also the world’s de facto reserve currency – it’s the only currency that almost anyone anywhere is ready to accept and so everybody wants to keep a precautionary store of it.

As a result, US interest rates filter through to the entire international economy as well. The US dollar is the primary currency of international finance – so that when the interest rate on US government bonds goes up, it becomes more costly not only for the US treasury to borrow at home but also for any government, company or individual almost anywhere in the world to borrow from abroad. Nor is that the end of the story. The differential between the interest rates on government bonds in different countries is a key determinant of exchange rates.

All other things being equal, if the interest rate on the US government’s bonds rises when the interest rate on the British government’s bonds remains unchanged, investors will try to rebalance their investments towards US bonds and away from British ones. As they do so, they will drive down the value of the pound sterling relative to the US dollar.

Even small changes in the interest rate on US government bonds can have a big effect on the relative value of currencies in this way – especially in the emerging markets. In the few weeks since Bernanke made his remarks, the currencies of Mexico, South Africa and Brazil, for example, have all lost more than a tenth of their value against the US dollar. This is extreme volatility of exchange rates and it can be highly disruptive of international trade and finance.

In short, the interest rate on American government bonds is the single most important regulating factor in the world economy. It’s no wonder that James Carville, Bill Clinton’s electoral strategist, reflected ruefully in 1993, “I used to think if there was reincarnation, I wanted to come back as the president or the pope . . . but now I want to come back as the bond market. You can intimidate everybody.”

So is it a good or a bad thing that US interest rates are on the rise following Bernanke’s recent pronouncements? It used to be easy to answer to that question. The link between the central bank policy or base rate and government bond yields was simple. When the economy was in rude health, the central bank would hike its policy rate and the interest rate on government bonds would rise; and when the economy was running out of steam, it would cut and bond yields would fall. Higher rates meant a healthier economy.

Since 2009, however, this transparent link between the bond market and the central bank has evaporated. With central bank policy rates stuck at zero, the bond market has had to take its cue not from monetary policy itself but from officials’ speeches and journalists’ scoops. The utterances of central bank officials such as Bernanke have become major economic data in their own right. The medium has become the message.

The result has been to turn investing in government bond markets into a kind of monetary Kremlinology, in which every passing comment of central bankers is minutely parsed for clues to the true direction of policy. In June, the new Kremlinologists concluded from Bernanke’s latest oracle that the global economy was in robust enough shape to tolerate a rise in the all-important interest rate on US government bonds.

For all our sakes, we had better hope that the divinations of the new Kremlinologists turn out to be more accurate than those of the old ones.

Traders work on the floor of the New York Stock Exchange. Photograph: Getty Images

Macroeconomist, bond trader and author of Money

This article first appeared in the 01 July 2013 issue of the New Statesman, Brazil erupts

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Brexit broke my heart - but I'm going to fight for the 16 million who voted Remain

We must accept the voters' decision, but not give up on our beliefs.

The European Community, an institution that we built, that delivered peace, that promoted equality, kept us safe and opened the doors of opportunity, will no longer play part of Britain’s future. As one of the 16 million remain votes and a passionate pro-European the result hurts me deeply.

With this vote, the very fabric of our country has changed, the whole fabric of Europe has been changed.

Even though the vote was close, the majority of British people want us to leave. We must accept that decision but we refuse to give up on our beliefs.

Our optimistic, hopeful, diverse and tolerant Britain is needed now more than ever.

The Liberal Democrats will continue to stand for a better kind of Britain than the one painted by the Leave campaign. Since the polls closed thousands of people have joined our party as they look across at Labour party who dont seem to care. Their spineless leadership has meant we have sleepwalked to Brexit.

As Gladstone said almost 130 years ago – ‘We are part of the community of Europe, and must do our duty as such.’

We must not let this vote allow our country to turn to division, isolation and decline. Our national interest does not end at the cliffs of Dover.

I believe that this vote was not a vote on the European Union alone. It was a collective howl of frustration - at the political class, at big business, at a global elite.

Years of frustration, dissatisfaction and people feeling ignored have been building to this point.  Too often the European Union has been used as a distraction from failures in government.

The pressures on our schools, the pressures on our hospitals and GP surgeries, the pressures on our infrastructure are problems made in Westminster, in our own Parliament, by British politicians.

For the last few weeks I have stood alongside progressives, in Labour, Greens and Conservatives. It felt so much like there was more that united us than divided us.

We must not allow this unity to fade away.

When other parties are divided and wounded, I will reach out. I am proud of the campaign that my party has run, it was positive, energetic and hopeful. That’s the sort of party we are, and that is my offer to the country. It is my offer to all people who share our values.

I can offer you a home for a new modern breed of politics - liberal, hopeful, international, rational - driven by real British values.

Positive about Europe, furious with those who led us to this disaster. Determined that we will not walk away from this fight.

There are 16 million of us saying that this fight is not over. This is our country too. If you are as angry and heartbroken as I am, I need you to join us today.

 

Tim Farron is leader of the Liberal Democrats.