Are high UK yields good or bad?

The UK gets widely panned for being a fiscal basket case, but the opposite is true

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There’s no denying that long-term yields on UK government bonds are considerably higher than in other advanced economies, which - in the popular narrative - is seen as a sign of weakness. That’s not right and today’s post pushes back on this. High yields are neither good nor bad. They’re a market price and - if your fiscal trajectory is bad - high yields are the only thing that incentivizes governments to make unpopular but needed changes. It’s worse if your debt dynamics are bad and you force your central bank to artificially cap yields, which is what goes on in Japan and the Euro zone. This just hides from the problem and makes it grow over time. High UK yields are a sign of transparency and price discovery. In the end, that’ll stand the UK in good stead, even if the path to fiscal consolidation is difficult and messy. It always is, so that’s not a knock on the UK.

There’s two reason why high UK yields aren’t terrible. First, the UK only stands out because Japan and the Euro zone use their central banks to artificially cap long-term yields. In Japan, the central bank buys huge amounts of government bonds every month, while in the Euro zone the ECB in 2022 - when high-debt countries like Italy and Spain were struggling - intervened in markets to cap yields and introduced a new facility to normalize this going forward (TPI). The two charts above show the 30-year government bond yield on the left and the 10y20y forward yield (backed out from 20- and 30-year yields) on the right. You can’t compare these because Japan and the Euro zone artificially cap yields. The UK does not.

Second, as I’ve argued in previous posts, using your central bank to artificially lower yields doesn’t reduce your fiscal risk premium. It just pushes it from the bond market into the currency. The best way to see this is to compare Japan and the UK, which are in the two charts below. The left chart shows the trade-weighted Yen versus the G10 in black, in addition to the 10-year yield in blue plus 10y10y (backed out from 20- and 10-year yields) and 10y20y forward yields in red and orange, respectively. The right chart is the same thing for the UK. Bank of Japan bond buying prevents yields from rising to levels markets would like to see. This means that - adjusting for fiscal risk - yields are too low and therefore people exit Japan, driving the Yen down. In the UK, yields are allowed to rise freely and - as a result - the Pound is stable against its peers. The point is that a fiscal risk premium shows up one way or another. The UK is just being transparent about this, while Japan isn’t.

High yields aren’t a walk in the park, but they’re a lot better than artificially capping them. The UK government is getting the “truth” from markets, which will force it to do the right thing eventually. Japan and the Euro zone are stuck in denial.