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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Leader: Europe and the long shadow of war

Amid the rancour, it is easy to forget what drove European integration in the first place: the two great wars in the first half of the 20th century.

Amid all the claims and counterclaims about David Cameron’s so-called renegotiation of Britain’s membership of the European Union, it is often forgotten, or conveniently ignored, just how successful the European project has been in helping to create and maintain the post-Second World War peace order.

We support continued British membership of the EU but are sceptical of the imperial ambitions of the European elites. We opposed British membership of the single currency, a decision that the eurozone crisis has vindicated. It is obvious that the Schengen Agreement is unravelling and in all likelihood is unsustainable, as embattled nation states reimpose emergency border controls and the continent grapples with its worst refugee crisis since the end of the Second World War. Like the British government, we are opposed to further political and economic integration and to the creation of a federal or quasi-federal superstate.

However, at a time of profound instability in the world, we accept that it would be foolish for the United Kingdom to retreat from our various multilateral peace alliances – whether that be membership of the EU or, indeed, Nato (as some on the left would wish) – all of which involve some kind of surrender of sovereignty.

Amid the rancour, it is easy to forget what drove European integration in the first place. The two great wars in the first half of the 20th century racked the continent, with neighbouring armies slaughtering each other on a scale that still defies comprehension. As Alistair Horne writes on page 22, “the most atrocious battle in history” began a century ago next week in Verdun, France, on the Western Front. The German army hoped to lure the enemy into a trap and then “bleed the French army white” using its superior firepower. Yet the rivers of blood flowed both ways: in ten months, over 25 square miles, pounded by heavy artillery and poisoned with gas, 300,000 French and German soldiers died.

The lessons of the battle were not quickly learned – the carnage of the Second World War was still to come – yet ultimately they were. In 1963, France’s Charles de Gaulle, who was wounded at Verdun, signed a treaty with the then German chancellor, Konrad Adenauer, binding two countries that had engaged for centuries in tit-for-tat wars in an enduring nexus of co-operation. The aim, as David Reynolds notes in his article on page 28, was “to free the next generation from the vice of nationalism”.

Two decades later, President François Mitterrand, who fought near Verdun in 1940, and Chancellor Helmut Kohl, whose father served there in 1916, attended a commemoration ceremony at one of the battle sites. In what became an iconic image of reconciliation at the heart of Europe, Mitterrand impulsively gripped Kohl’s hand during their national anthems. The two men were later the architects of the Maastricht Treaty, which created the European Union under its current name.

These are troubling times for Europe. Confidence and optimism are low. The wars in the Middle East and the rise of Islamic State, Russian revanchism and financial and economic turbulence have dented the morale of even the most committed liberal Europhiles. In addition, the EU seems unable or unwilling to control or police its borders, just as it has been unable to bring an end to the crisis in the eurozone. Nor is it any closer to forging a common foreign policy, let alone forming a common European army that might be necessary in future years to patrol the outer edges of the continent.

“Unless the EU can find solutions to the problems Europe is facing that are acceptable to its members . . . the Union will be on a glide path to collapse,” wrote the historians Brendan Simms and Timothy Less in a recent issue of the New Statesman. And yet, for all its flaws and present difficulties, the EU remains a force for stability in the world. It embodies the liberal, rules-based order without which barbarism and war are never far away, as the centenary of the Battle of Verdun so poignantly reminds us. 

This article first appeared in the 11 February 2016 issue of the New Statesman, The legacy of Europe's worst battle