There might be a simple reason for this - that markets are pricing in permanently low short-term rates, perhaps because they expect low long-term growth. Bank of England governor Mark Carney recently said that 2.5 per cent could be the "new normal" for Bank rate. If he's right, gilt yields should stay around current levels. This is because the expectations hypothesis of the yield curve tells us that long-term yields should be equal to the average expected short-term interest rate during the lifetime of the gilt. If we expect Bank rate to average 2.5 per cent over the next 10 years, therefore, 10-year gilt yields should be 2.5 per cent - which is not far from where they are now.
This poses the question: what could happen to significantly raise yields?
The obvious possibility is simply that fear of stagnation and low interest rates could prove wrong. However, they mustn't be wrong merely in the UK. For gilt yields to rise a lot, they must also be wrong for the eurozone, too. However, with the region's economic recovery failing to gain momentum, many economists fear that the ECB will keep interest rates near zero for years. This would hold down yields on German bonds and because these are a substitute for gilts, yields on the latter would also stay low.
Another possibility is that the expectations hypothesis is wrong.
One way in which this could be the case is if investors require a risk premium for holding longer-term assets; if this is so, longer-dated gilt yields should be above expected short rates.
But it's unclear whether this is the case. Granted, since 1988 10-year yields have averaged 0.4 percentage points more than Bank rate. But this might tell us not that there's a risk premium in gilts but rather that Bank rate has turned out to be lower than expected on average. And even if this is a measure of the risk premium, it still implies that 10-year yields will be less than 3 per cent.
A second way in which the expectations hypothesis might be wrong is if the gilt market is segmented, with some investors preferring different maturities; if this is the case, then (say) 10-year gilts are not a substitute for (say) a one-year gilt reinvested nine times, in which case 10-year yields won't be equal to expected short rates. If this is so, then 10-year gilts could sell off if China's savings glut diminishes, if quantitative easing is reversed or if an ageing population reduces demand for longer-term assets.
However, all these will be long-term forces, if they operate at all. They don't give us a reason for expecting a sharp sudden rise in yields.
There is, though, another possibility. It's that gilt yields overreact; they fall too far when Bank rate is low, and rise too much when it is high. One piece of evidence for this is that there has been a strong correlation between annual changes in Bank rate and in 10-year yields - of 0.46 since 1986, with a one percentage point change in Bank rate associated on average with a 0.25 percentage point change in 10-year yields. This is more than one would expect if 10-year yields were merely a rational expectation of future short rates, because a move in Bank rate today shouldn't tell us much about short rates in 10 years' time.
If gilts do overreact, there are two implications. One is that yields might be too low now because the market is overreacting to a low Bank rate and the possibility of secular stagnation. The other is that when Bank rate does rise, gilt yields will also do so. And even if Mr Carney is right and 2.5 per cent does prove to be the new normal for Bank rate, gilt yields could overshoot when Bank rate temporarily rises above this level; 2.5 per cent is 'normal', remember - not a ceiling.
There are, therefore, reasons to suspect that gilt yields could rise. However, on balance I fear that my earlier expectation that they would do so significantly might have been mistaken; I might have overestimated cyclical factors and underestimated the power of secular stagnation.
This has important implications for those of us approaching retirement. It suggests that annuity rates might not rise very much, or at least that we shouldn't bank on them doing so (although the gilt yield curve is pricing in some rise in them). This gives us some awkward options: to save more; or to postpone retirement; or take on more equity risk by staying invested in shares and using some type of drawdown to generate a retirement income. Whichever, our options might have worsened.
