Detoxifying government debt, part 2. Market myths

 

“Labour’s biggest opponent is no longer the Conservative Party. It is the bond market.” That was the first sentence I read a few days ago in an article in a respected publication. It works as a first sentence because it sounds all too plausible given the way the media treats the financial markets in general, including the market for government debt (the ‘bond market’). I once described the media as seeing financial markets like a vengeful god: a powerful but mysterious entity that has the potential to create havoc, and that therefore has to be treated with great respect and offered the occasional sacrifice, like less help insulating homes.

Who do you get to explain the behaviour of a vengeful god? The high priests of the vengeful market are the small band of economists working for City firms who get quoted in newspaper articles or appear on our television screens because they are 'close to' the markets. But these economists are no closer to the financial markets than someone on the till at Tesco’s is close to supermarkets. They are employed by City firms mainly to sound knowledgeable to wealthy clients rather than advise market traders. The unfortunate truth is that what they tell the media is pure guesswork, based on no evidence at all.

When one of them tells you ‘the markets are nervous at the prospect of’ some event, do you think they have conducted a survey of the thousands of people trading in the market that morning to ask them how they are feeling? Of course not. But the media want them to appear like experts with knowledge, so they tell what they think are plausible stories related to recent (often political) events.

All this adds to the perception that how financial markets work is deeply mysterious, and beyond the understanding of anyone unfamiliar with finance. It also adds to the idea that market traders are making judgemental decisions about political actions. The truth is very different. When it comes to the bond market the way it works is normally very simple, and easily understandable for anyone who has thought about saving in a fixed interest rate savings account, or anyone with a mortgage who has wondered about whether to get one with a fixed or variable rate. In reality financial markets are not a vengeful god but a pricing mechanism. The best way to detoxify market myths is with some knowledge, so here is a simple guide to how the bond market works.

Imagine you need to decide whether to invest your money in a variable interest rate savings account, or one that has a fixed interest rate for 3 years. If you think the variable rate will be above the fixed rate for most of those 3 years you would choose the variable rate and vice versa. In other words your choice is based on how you think short term interest rates will vary over the next three years, plus some allowance for any lack of freedom tying your money up for three years implies (the ‘liquidity premium’).

As most government debt has a fixed interest rate for a number of years, this is all that the bond market is doing. This pricing mechanism is often called arbitrage. There is nothing inherently difficult or complex involved that is beyond the understanding of most people. Market traders are trying to guess how central banks will set interest rates in the future, and they can get that wrong as much as any macro forecaster. The aim of these traders is just to make money, not to pass judgement on some political decision. The media stories you hear are plausible if and only if political events or decisions influence central bank decisions about short interest rates over the next few years. Those central bank decisions, as we know, depend on the Bank’s expectations about inflation. [1]

If arbitrage is the right way to think about how the bond market works most of the time, it is worth mentioning two alternative ways which are wrong most of the time. The first is to think about supply and demand. That works with the market for apples, because people have preferences for consuming apples and are often prepared to pay more if the supply of apples becomes scarce. But those preferences generally don’t exist for financial assets. [2] These assets are just a way of earning interest, and are not a consumption good. If some established national bank is offering permanently 0.25% higher interest on savings than some other bank, there is no reason to stick with the other bank.

If that seems obvious, then think about how often people in the media use supply and demand in talking about government borrowing. We were told after the Global Financial Crisis (GFC) that because government borrowing was going up sharply, so would interest rates, and so we had to get borrowing back down by cutting spending. In reality interest rates on government debt fell after the GFC because central banks cut short term rates, just as you would expect from the arbitrage process described above.

The second bad analogy often used for government debt comes from personal experience in borrowing, and involves repayment risk. If you are trying to borrow money, any lender will look at how likely you are to repay that money, and what the risks are that you will default on the loan. A similar logic will apply to individual firms that borrow to invest. However this way of thinking just isn’t relevant to the debt of advanced countries with their own currency like the UK, US or Japan. The reason is that these governments can always create the money to pay back the debt.

This is why the government debt of these countries are called safe assets. There is no risk of forced default, and these governments will never choose to default because of the cost that involves. There is a risk that inflation will devalue these assets (unless they are index linked), but because high inflation will lead to central banks raising interest rates that is already part of the arbitrage pricing mechanism described above.

How can governments create money when their central banks are independent? Central banks do it for them, by creating money (called ‘reserves’) to buy government debt. The central banks of the US, UK and Japan, along with other advanced countries that borrow in their own currency, are the buyers of last resort for government debt.

While the analogies of supply and demand or individual repayment risk are inappropriate to thinking about the way markets deal in and price UK government debt, we do need to add one final factor to the more realistic arbitrage model. While traders can make their best guess about where central banks will set short term interest rates over the life of the debt they are thinking of buying or selling, that forecast is uncertain. Because government debt is a safe asset, the people ultimately buying the debt (pension funds, banks etc) want less uncertainty, not more.

If the prospects for inflation, and therefore for future short term interest rates set by the central bank, become so uncertain they are almost impossible to forecast, buyers may decide that, for the moment at least, it is better to keep their money in short term assets or some other country’s government debt. The most charitable explanation for City economists talking about ‘nervous markets’ is that they think the level of forecasting uncertainty has increased. In extreme circumstances the uncertainty may be so great that traders withdraw and the market becomes very thin. Only at that point do considerations of demand and supply matter, but equally that is exactly the point at which central banks become the debt buyer of last resort to stabilise markets.

As the job of central banks is to stabilise inflation, the economy and financial markets, they will act when the market for government debt stops working well because it has become too thin. To a first approximation ‘not working’ means that arbitrage, the pricing mechanism of the bond market, is no longer working.

We saw this globally as the pandemic hit. In those initial days that Covid swept across the planet no one knew how to forecast anymore, and the markets for government debt in the major economies froze. The central banks stepped in to buy government debt. Hardly anyone outside of the financial markets noticed.

As we will see in Part 3, this again became important in the much misunderstood crisis following the fiscal event of Truss’s ill-fated premiership. Like it or not, the major fear in politician’s minds about additional government borrowing comes from fear of a crisis like this. During the Truss crisis we will see the three elements discussed in this post at work: arbitrage (expectations about central bank decisions), uncertainty about these expectations, and finally central banks stepping in to stabilise markets.

The key point of this post is that equating higher interest rates with more borrowing will be wrong most of the time, just as it was during the GFC and the pandemic. If you want to borrow larger amounts from the bank you may have to pay more (if you can get a loan at all), but just as in part 1 we see that governments are not like individuals. Unlike an individual, there is no risk of UK government debt not being repaid. Nor is the price at which the government borrows determined by supply and demand, because in normal times arbitrage ensures it is tied to expectations about future central bank decisions about short term interest rates. On the odd occasion that arbitrage fails because of extreme uncertainty, the central bank steps in as the buyer of last resort.

So the next time some City economist is quoted in the media relating interest rates on UK government debt to some political decision or event, ask yourself how that event relates to central bank decisions about short term interest rates. The next time they say the market is nervous about something, ask yourself has there really been a step change in forecast uncertainty? The media may treat the bond market as some mysterious entity that only those ‘close to it’ can interpret for us, but in reality it all comes down to the basic macroeconomics of central bank interest rate setting.

[1] This makes it sound as if central banks have complete control over longer term interest rates through their setting of short rates. But the aim of central banks is to control inflation, and what level of short term interest rates achieve that control will depend on what is sometimes called the neutral or natural rate of interest (or r*), which in turn will be influenced by various factors beyond the central bank’s control.

[2] At the extreme, supply and demand for government debt may influence rates if either demand dries up (see discussion below) or demand increases dramatically. The latter was one theory behind Quantitative Easing (QE): that by buying huge quantities of government debt, the central bank could have some (small) additional influence on longer term interest rates. The extent to which that is true in practice is still subject to debate, but because QE involved huge changes in demand it is not relevant to the discussion here.