UK: Deloitte Monday Briefing: Why Are Bond Yields So Low?

Last Updated: 10 September 2012
Article by Ian Stewart

The Monday Briefing, written by Ian Stewart, Deloitte's Chief Economist in the UK, gives a personal view on topical financial and economic issues.

  • One of the striking features of the financial scene today has been the extraordinary low level of interest rates on the bonds of major industrialised nations.
  • Interest rates – or yields - on ten year bonds issued by the UK government are at the lowest level since 1703. Over the summer yields on German and Swiss two year bonds turned negative, creating the remarkable situation in which investors are paying for the privilege of lending money to governments.
  • Not everyone has benefitted from this process. Despite last week's announcement by the European Central Bank of unlimited bond buying, the cost of borrowing for ten years for the Greece government is more than ten times what Germany pays.
  • Yet for the countries in the northern part of the euro area, and pretty much all industrialised countries elsewhere, the cost of borrowing for the government is exceptionally low.
  • For these countries high levels of government borrowing haven't deterred investors from buying government debt. Indeed, US ten-year bonds have risen in value by 11% since Standard Poor's downgraded America's debt rating citing concerns about the ability of the government to control the deficit.
  • Four factors seem to be at work.
  • Demand for safe assets has risen as the uncertainties confronting the world economy have risen. Investors are willing to pay a premium to insure against the risk of big declines in the value of their capital. So in the UK investors have kept buying government bonds despite the fact that interest rates on bonds have failed to keep up with inflation for four years.
  • Declining growth expectations in the industrialised world point to lower returns on risky assets such as equities. This process has supported demand for government bonds and, in turn, reduced yields. (The interest rate on bonds declines with rising bond prices).
  • Government bonds offer protection against the risk of deflation. At the end of its term investors are assured of getting their money back.
  • Meanwhile, the financial crisis has created powerful new sources of demand for government bonds. To counter the risk of deflation central banks have embarked upon Quantitative Easing - buying government bonds on a huge scale. In addition to that, regulation designed to strengthen the financial sector has led banks to increase their holdings of government bonds.
  • Japan offers a cautionary tale of how deflation, low growth and uncertainty can drive yields on interest rates to extraordinarily low levels. Over the last 20 years, Japan has experienced weak growth peppered with bouts of falling prices. Borrowing by Japan's government has soared and, relative to the size of its economy, its government is now the industrialised world's most indebted. Yet ten-year Japanese bond yields, at just 0.8%, are less than half US levels and are lower than in any country other than Switzerland.
  • It would be complacent to say that the cost of borrowing is unaffected by levels of government debt. Yet in an uncertain world, where growth and inflation are expected to run at low levels, government debt seems, for many investors, to be the least-worst place to put their money.
  • Some commentators argue that we are experiencing an unsustainable bubble in governments. Certainly bond prices have risen at a remarkable rate in recent years.
  • Whether an asset price boom is sustainable depends on whether the fundamentals of the economy have changed. If we are in a new normal world of elevated risk, weak growth and low inflation, current ultra low bond yields may be here to stay. If not, bonds are heading for a fall.

MARKETS & NEWS

UK's FTSE 100 ended the week up 1.5%, driven by mining shares and optimism following the announcement of the ECB bond buying plan.

Here are some recent news stories that caught our eye as reflecting key economic themes:

KEY THEMES

  • The euro strengthened to a two-month high against the US dollar, following announcement of the European Central Bank (ECB) bond-buying plans – ECB
  • The Organisation for Economic Cooperation and Development (OECD) downgraded its forecast for GDP growth in the UK to -0.7% for 2012, from a previous estimate of 0.5% growth - slowdown
  • Ratings agency Moody's downgraded the credit rating for the European Union to "negative", on concerns over the bloc's largest economies – eurozone crisis
  • The US economy created a lower-than-expected 96,000 jobs in August, according to data from the Bureau of Labor Statistics – US employment
  • Only 26% of Germans think Greece should stay in the eurozone or receive further help financial assistance from the eurozone according to a Financial Times/Harris poll – fragmenting eurozone
  • Data from the ECB shows Spanish small businesses are facing their highest bank borrowing costs in almost 4 years, whilst German businesses are borrowing at record lows – eurozone divergence
  • The Spanish government announced that it intends to create a "banco malo" (bad bank) into which all the toxic property assets of its banking sector can be off-loaded – banking stress
  • Capital outflows from Spain have totalled 52.3% of the country's GDP on a 3-month rolling basis, according to data from Nomura – capital flight
  • Investment grade US companies have issued $5.6bn of euro denominated debt in the last 4-months, compared to $2bn issued in both 2010 and 2011, according to data from Dealgoic – corporate debt
  • The UK is the 8th most competitive economy in the world, up from 10th last year, according to the 2012/13 World Economic Forum global competitiveness league table – competitiveness
  • Dyson, the UK household appliances firm, reported record annual turnover of £1.05bn, led by "robust growth" in the US and Japan – export growth
  • UK manufacturing output grew by a better-than-expected monthly rate of 3.2% in July, the strongest rise since July 2002 – manufacturing growth
  • Consumer electronics firm Apple Inc. is now worth $624bn, more than all the listed companies in Portugal, Ireland, Greece and Spain together – Apple
  • Luxury clothing firm Hermes International reported higher than expected profits for the first half of 2012, driven by strong demand in China for its Birkin bags and silk scarves – emerging markets
  • The Greek government is under pressure from its international lenders to "increase the number of maximum workdays to six days per week", according to a leaked letter – Greece
  • Fast food chain McDonald's is to open its first two vegetarian outlets in the holy Indian sites of Amritsar and Katra, serving the "McVeggie" among other vegetarian dishes – emerging markets

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