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

Felix Martin is a macroeconomist, bond trader and the author of Money: the Unauthorised Biography

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

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Britain has built a national myth on winning the Second World War, but it’s distorting our politics

The impending humiliation of Brexit is going to have a lot more in common with Suez.

The Crown, Peter Morgan’s epic drama covering the reign of Elizabeth II, ended its first series with a nemesis waiting just off-stage to shake up its court politics. In the final episode, Egyptian president Gamal Nasser gives a rip-roaringly anti-imperialist – and anti-British – speech. The scene is set for the Suez Crisis to be a big plot point in Season 2.

Suez has gone down in history as the great foreign policy debacle of postwar Britain. The 1956 crisis – which saw Israel, France and Britain jointly invade Egypt to take control of the Suez Canal, only to slink off again, nine days later, once it became clear the US wasn’t having any of it – is seen as the point at which it became clear that even the bigger states of Europe were no longer great powers in the world. “President Eisenhower’s humiliation of Britain,” Jack Straw wrote in his 2012 memoir, “had been total.”

This was, though, a fairly limited sort of humiliation. Britain was not invaded or occupied; there was no sudden collapse in living standards, let alone a significant body count. Our greatest national debacle is nothing more than the realisation that Britain could no longer do whatever it wanted without fear of reprisal. As humiliations go, this one’s up there with the loss of status men have faced from the rise of feminism: suddenly, Britain could do what it wanted a mere 80 per cent of the time.

The Crown begins in 1947, when Prince Philip gives up his Greek and Danish royal titles and becomes a British subject, so that he can marry Princess Elizabeth. That year saw another British foreign policy debacle, one on which the show remains oddly silent. In the partition which followed India’s independence from the British Empire, 70 years ago this week, upwards of a million people died; in the decades since, the borders drawn up at that time have been the site of numerous wars, and Kashmir remains a flashpoint.

All this, one might think, might count as a far bigger regret than Suez – yet it doesn’t feature in the national narrative in the same way. Perhaps because partition was about the withdrawal of British forces, rather than their deployment; perhaps it’s simply that it all happened a very long way away. Or perhaps we just care less about a body count than we do about looking bad in front of the Americans.

I think, though, there’s another reason we don’t talk about this stuff: the end of empire is hidden behind a much bigger part of our national myth. In the Second World War, Britain is undeniably one of the good guys; for 12 months, indeed, Britain was the only good guy. Never mind that it still had the largest empire the world had ever seen to fall back on: Britain stood alone.

The centrality of the Second World War to the national myth warps our view of history and our place in the world in all sorts of ways. For starters, it means we’ve never had to take an honest account of the consequences of empire. In a tale about British heroes defeating Nazi villains, British mistakes or British atrocities just don’t fit. (Winston Churchill’s role in the 1943 Bengal famine – death toll: three million – by ordering the export of Indian grain to Britain rarely comes up in biopics.) In this dominant version of the national story, the end of empire is just the price we pay to defeat fascism.

More than that, our obsession with the Second World War creates the bizarre impression that failure is not just heroic, but a necessary precursor to success. Two of the most discussed elements of Britain’s war – the evacuation of Dunkirk, and the Blitz – are not about victory at all, but about survival against the odds. The lesson we take is that, with a touch of British grit and an ability to improvise, we can accomplish anything. It’s hard not to see this reflected in Brexit secretary David Davis’s lack of notes, but it’s nonsense: had the Russians and Americans not arrived to bail us out, Britain would have been stuffed.

Most obviously, being one of the winners of the Second World War infects our attitude to Europe. It’s probably not a coincidence that Britain has always been both one of the most eurosceptic EU countries, and one of the tiny number not to have been trampled by a foreign army at some point in recent history: we don’t instinctively grasp why European unity matters.

Once again, Suez is instructive. The lesson postwar France took from the discovery that the imperial age was over was that it should lead a strong and unified Europe. The lesson Britain took was that, so long as we cosied up to the US – Athens to their Rome, to quote Harold Macmillan – we could still bask in reflected superpower.

Until recently, Britain’s Second World War obsession and national ignorance about empire didn’t really seem to affect contemporary politics. They were embarrassing; but they were also irrelevant, so we could cope. Brexit, though, means that hubris is about to run headlong into nemesis, and the widespread assumption that Britain is a rich, powerful and much-loved country is unlikely to survive contact with reality. India will not offer a trade deal for sentimental reasons; Ireland is not a junior partner that will meekly follow us out of the door or police its borders on our behalf. The discovery that Britain is now a mid-ranking power that – excepting the over-heated south-east of England – isn’t even that rich is likely to mean a loss of status to rival Suez.

Morgan says he has planned six seasons of The Crown. (This looks entertainingly like a bet the Queen will be dead by 2021; if not, like Game of Thrones before it, he might well run out of text to adapt.) It’ll be interesting to see how the show handles Brexit. It began with the royal family facing up to a vertiginous decline in British power. As things stand, it may have to end the same way. 

Jonn Elledge edits the New Statesman's sister site CityMetric, and writes for the NS about subjects including politics, history and Brexit. You can find him on Twitter or Facebook.

This article first appeared in the 17 August 2017 issue of the New Statesman, Trump goes nuclear