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

Ukip's Nigel Farage and Paul Nuttall. Photo: Getty
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Is the general election 2017 the end of Ukip?

Ukip led the way to Brexit, but now the party is on less than 10 per cent in the polls. 

Ukip could be finished. Ukip has only ever had two MPs, but it held an outside influence on politics: without it, we’d probably never have had the EU referendum. But Brexit has turned Ukip into a single-issue party without an issue. Ukip’s sole remaining MP, Douglas Carswell, left the party in March 2017, and told Sky News’ Adam Boulton that there was “no point” to the party anymore. 

Not everyone in Ukip has given up, though: Nigel Farage told Peston on Sunday that Ukip “will survive”, and current leader Paul Nuttall will be contesting a seat this year. But Ukip is standing in fewer constituencies than last time thanks to a shortage of both money and people. Who benefits if Ukip is finished? It’s likely to be the Tories. 

Is Ukip finished? 

What are Ukip's poll ratings?

Ukip’s poll ratings peaked in June 2016 at 16 per cent. Since the leave campaign’s success, that has steadily declined so that Ukip is going into the 2017 general election on 4 per cent, according to the latest polls. If the polls can be trusted, that’s a serious collapse.

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In the 2015 general election Ukip contested nearly every seat and got 13 per cent of the vote, making it the third biggest party (although is only returned one MP). Now Ukip is reportedly struggling to find candidates and could stand in as few as 100 seats. Ukip leader Paul Nuttall will stand in Boston and Skegness, but both ex-leader Nigel Farage and donor Arron Banks have ruled themselves out of running this time.

How many members does Ukip have?

Ukip’s membership declined from 45,994 at the 2015 general election to 39,000 in 2016. That’s a worrying sign for any political party, which relies on grassroots memberships to put in the campaigning legwork.

What does Ukip's decline mean for Labour and the Conservatives? 

The rise of Ukip took votes from both the Conservatives and Labour, with a nationalist message that appealed to disaffected voters from both right and left. But the decline of Ukip only seems to be helping the Conservatives. Stephen Bush has written about how in Wales voting Ukip seems to have been a gateway drug for traditional Labour voters who are now backing the mainstream right; so the voters Ukip took from the Conservatives are reverting to the Conservatives, and the ones they took from Labour are transferring to the Conservatives too.

Ukip might be finished as an electoral force, but its influence on the rest of British politics will be felt for many years yet. 

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