- Signs of economic recovery have not raised Index-linked gilt yields yet.
- This reflects long-standing global factors such as the shortage of safe assets and weak economic growth.
The UK economy is recovering well. Since November real GDP has risen 3.5 per cent; the number of workers on payrolls has risen 1.5 per cent; and cyclical shares have soared.
One big asset class, however, doesn’t seem to have realised this – index-linked gilts. Yields on five-year linkers have actually fallen slightly since November and are still close to record levels. Which is odd, because an economic recovery should reduce demand for safe assets and so raise yields.
So, why hasn’t it? One obvious possibility is that the Bank of England’s buying of £450bn of gilts since last March has held down yields.
This, though, is only part of the story. For one thing, Bank buying has only offset the increased supply of gilts caused by record government borrowing. Official figures show that central government debt held by people other than the Bank of England actually rose by £141.5bn last year. And for another, there have been no new announcements of quantitative easing since November, so QE shouldn’t explain the failure of index-linked gilts to rise since then.
A second suspect is the Bank of England’s promise not to raise rates until there is “clear evidence” that its inflation target will be hit “sustainably.” This points to short-term interest rates being significantly negative for some months. And because real five-year yields should be equal to the expected path of real short rates over the next five years, this naturally holds down yields.
Again, though, this is only part of the story. Even if signs of economic recovery and inflation haven’t changed rate expectations for the near-term, they should have increased them for 2023 and beyond, and this should have raised five-year yields.
A further possibility is that rising inflation expectations have caused increased demand for index-linked gilts.
But this shouldn’t be the case. Such expectations should cause a sell-off in nominal gilts, and leave index-linked yields little changed or even higher. True, linkers’ yields could fall if investors expected inflation to be confined to the UK – because in such an event nominal yields would be held down by overseas yields. But this doesn’t apply now: rising inflation in the euro zone and US suggest that the inflation threat is global, not local.
All this leaves us with the need for other explanations. These should start from two facts.
Fact one is that, as my chart shows, there has been a huge downtrend in real yields since the mid-1990s. Yes, yields do rise in better economic times and fall in worse ones, but this tendency is weak compared with the downtrend – a trend which not only pre-dated quantitative easing, but continued even during periods when the Bank wasn’t doing any such easing.
Fact two is that the UK is not alone is seeing near-record low yields. In the US, yields on five-year inflation-proofed Treasury bonds are only 0.2 percentage points above their record low. This is despite the fact that President Biden’s fiscal stimulus should in theory raise yields.
These facts tell us that there have been longstanding world-wide forces pushing real yields down.
One of these is a shortage of safe assets. Savers, especially outside of western economies, have for years had few safe havens for their money and so have piled into the few assets that offer such security, such as western government bonds. In recent months, this safe asset shortage has intensified. The pandemic has increased the risk of default on lower quality bonds and reminded investors of the fragility of the world economy. And rising oil prices since last summer have boosted the revenues of oil producers – revenues which have been recycled into western bonds.
Also, western economies have fallen into what Harvard University’s Larry Summers has called secular stagnation – a phase of weak growth in which ultra-low interest rates are needed to support the economy even in normal times. An under-appreciated cause of this is that returns on physical assets (and expected returns on them) have fallen – which means that capital spending is weaker, the natural response to which is for real interest rates to be lower. One reason why markets are so jumpy about even small changes in the Fed’s intentions is that they fear that the world economy is too fragile to take strong monetary medicine.
We do, however, have an inkling that investors expect this to change. Ten-year yields are less negative than five-year ones, which implies that markets are pricing in rising yields – so much so that they expect five-year yields to be slightly positive by 2026. Given the history of the last 25 years, this represents a triumph of hope over experience.
