Bonds and the Bank

The decision by the Bank of England to become a big purchaser of government bonds through the tactic of quantative easing is already starting to have an effect on the gilt market and on government bond yields.

I keep telling my students to keep a careful eye on the market for government and corporate bonds as we progress through 2009 - it is not an area that usually commands much attention when discussing macroeconomic policy at AS or A2 level but it is now far too important to ignore.

The Bank of England is pursuing a policy of quantitative easing which - for the moment - involves purchasing government bonds of varying maturities and paying for them by creating fresh deposits on its balance sheet. This increases the demand for bonds and pushes their price up. But because the yield on a bond is inversely related to the market price of a bond (because the interest or coupon on a bond is fixed), a surge in bond prices is driving down bond yields. The benchmark 10-year gilt yield has dropped to just 2.95 per cent – the lowest level since records began in the 1950s. Yields on two year government bonds are even lower.

So for a government borrowing as if there is no tomorrow (maybe they know something we do not) the cost of financing the surging budget deficit is pretty low and the risks of financial crowding out where government debt drives long term interest rates higher and squeezes companies needing to issue new debt to expand seem to be modest. For the time being at any rate.

The Bank of England is buying government debt at a hefty price, but their main concern is to lower bond yields since mortgage rates and company bonds often take their cue from the benchmark yields - hopefully cheaper borrowing costs and improved liquidity will provide the basis for a recovery in lending and a turning point for the cycle.

The fly in the ointment is the effect of this on pension funds. Lower interest rates mean that the future value of pension liabilities (pensions that will have to be paid out in future years to those with entitlements) will be discounted at a lower rate to find today’s value - the result is that estimated pension fund deficits are growing and that will place pressure on those companies who have extra cash during a recession to put them into pension funds to lower pension deficits rather than invest in the growth of their business. The Financial Times reports that ‘The Pension Protection Fund, which compensates members of defined benefit schemes that fail, calculates that total deficits at these funds in the UK stood at £190.6bn at the end of January, up from £48.8bn in January 2008.’

Sooner or later the Bank of England will start to become a major purchaser of corporate bonds and also equities .... but I hope that they have also started to plan an exit strategy for a policy that few if any people really know will work.

Lower bond yields also have implications for sterling in the currency markets. A reduced return on bonds makes sterling less attractive to overseas investors - one reason why the pound is depreciating again against the US dollar - at the time of writing it is well below $1.40.

Gilt yields fall to 50-year low before first auction (Independent)