Risk-free government bonds? If only…

Suppose you had bought some UK government stocks at the beginning of December last year. After all, they are “risk free” in that you are as certain as anything is in this life that you will get the interest, and the capital repayment, on the due dates. If you were particularly unfortunate, you could have paid £170 for some Treasury 4.5 per cent 2042. Suppose also that you wondered what had happened since you bought it.

You would get quite a shock. The price of this risk-free security has fallen by a fifth in four months, to £138. Had you opted to lend your capital to the UK government for (only) 10 years instead, your paper loss would have been more like an eighth, less shocking, but still painful. Even that understates the dwindling purchasing power of your investment. Thanks to accelerating inflation, a pound last December is worth 98p today.

Today’s lower price can hardly be described as bargain-basement. The running yield is 3.5 per cent, a fixed return which would have seemed derisory at any time but the recent past. Sustained by the belief that somehow inflation was licked, and that there was no serious limit to governments’ ability to borrow for almost nothing, yields just kept going down. That process has now come to an end, and we are witnessing the unwinding of the great bull market in bonds, all round the world. The monetary madness that saw widespread negative yields – where you had to pay the government to look after your money – is finally fading.

In the US, the world’s driver of the bond markets, consider the Treasury 1 1/4 per cent 2050, issued at $98.03 in 2020. It now changes hands at $69. Grant’s Interest Rate Observer guestimates 5 per cent as a reasonable yield to investors for the longer term, which would take the price down to $44. Some risk-free return.

The mechanism that has allowed governments to pretend that they can borrow as much as they liked at tiny prices was quantitative easing, a thinly-disguised form of money printing. Governments could spend without taxing, central banks could pretend that they were in control of events, while inflation stayed almost unmeasurably low.

It’s slowly becoming apparent that the decade of price stability owed far more to emerging far eastern economies’ ability to make things more cheaply, helped along by the supply chain efficiencies driven by the information technology revolution. Consumers everywhere reaped the benefits. The central banks may have claimed the credit, but their policies were more effect than cause. The monetarists, who had almost given up warning of the consequences of so much money printing, were consistently ignored.

Now inflation has risen from the grave, and the government stock that the Bank of England bought in without a care for the price will have to find genuine buyers who care about it very much. They will see how much the Bank has to sell, and add it to the new stock which the government must issue to cover its incontinent spending.

The interest bill for this year, budgeted at £83 billion, is moving from just another cost to the government to becoming a major drain on the public finances. Interest rates are clearly going up, perhaps by quite a long way. In the US, reckons Matt King of Citicorp, far from being “priced into” bond prices, the adjustment has hardly begun. Since last December, potential buyers of UK government stocks have been able to sit back and watch prices fall. They might reasonably expect that they could watch them fall a good deal further yet.

Unhappy birthday

It’s going to be a sticky couple of weeks for the Bank of England, as the critics line up to administer a good kicking to the Monetary Policy Committee to mark the 25th anniversary of “independence” on May 6. Five years ago, in a prettily-produced presentation to go with a special conference, it was all so different. Inflation, we knew, had been permanently conquered, the central banks had mastered control of the debt markets, and the world economy was rattling along.

Now the MPC is accused of being asleep at the wheel, of failing to see that a Bank Rate stuck at 0.1 per cent was asking for trouble, and for forgetting that money, and the supply of it, matters. The evolving cast of committee members were not the only ones who thought that the monetary signals could be ignored; those of us who had warned about the dangers of inflation had been proved wrong so often that we became used to being told we were fighting yesterday’s battles.

Economists are as prone to fall for fashion as the rest of us, so it was hardly surprising that the benign conditions led to complacency, before the pandemic upended all the calculations and produced the emergency cut to (effectively) zero. The more serious criticism is whether the MPC has been effectively captured by a government which desperately needs low borrowing costs (see above). After a quarter of a century, we may be about to find out whether it is really independent at all.

Jonathan Ford and I produce a Podcast, A Long Time In Finance, every Friday. Listen on Spotify or Apple apps.