UK yields aren't nearly as bad as they look
UK yields are high because QT has been much more aggressive than elsewhere
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In October 2022, at the height of the bond market blow-up in the UK, something incredible happened. Governor Andrew Bailey told British pension funds the Bank of England would end its support program for the country’s fragile gilt market, drawing a line under how much help the central bank was willing to give to exposed pension funds and - implicitly - the government. By the end of that week, Kwasi Kwarteng - the finance minister - had resigned. Prime Minister Liz Truss would soon follow.
This episode is so incredible because it contrasts with what happened in the Euro zone earlier that year. Bond markets in Spain and Italy were under pressure amid high inflation and rising interest rates. In the middle of this, Mario Draghi - Italy’s Prime Minister - resigned, compounding pressure on bond markets of high-debt countries on the Euro periphery. Unlike the Bank of England, the ECB caved. It bought Italian and Spanish government bonds in an effort to cap yields and introduced a new tool that signaled to markets it might do such caps more frequently going forward.
Faced with pressure on bond markets, the ECB capitulated to political pressure from high-debt countries like Italy and Spain. The Bank of England stood its ground and toppled the Truss government. This kind of thing has long-lasting consequences. It means markets price a higher probability of yield caps in the Euro zone, which keeps Italian and Spanish yields artificially low, while markets feel free to push up UK yields without fear of central bank intervention. As I flagged in yesterday’s post, this means you really can’t compare UK yields to those of other high-debt countries. The UK looks worse, but only because its central bank isn’t interfering with markets.
There’s more to this than just that 2022 episode. The Bank of England has also been much more aggressive in its quantitative tightening (QT) than other central banks. If one motivation for quantitative easing (QE) is to lower bond yields - especially longer-dated ones - then it stands to reason QT pushes yields up. The left chart above shows a four-quarter moving average of UK government debt issuance (black line) in percent of GDP and which sectors absorb this issuance, including the Bank of England (blue bars). The right chart above compares the Bank of England’s accumulation or run-off of government bonds (blue line) with that of other central banks, where this blue line is the same as the blue bars in the left chart. The Bank of England was quicker and more aggressive than other central banks in downsizing its bond holdings, so UK yields will have risen more than elsewhere also for this reason, not just because of Governor Andrew Bailey’s remarks in October 2022.
When I started writing these Substack posts, I decided to call them “Shadow Price Macro.” A shadow price is a hidden price you can’t see because actual prices are distorted. What’s going on with global bond yields is a key example. The UK allows markets to do full price discovery. That means - on the surface - that gilt yields are higher, but - as I argued yesterday - that’s really a positive, not a negative.
No, I would not call that a “key example” of shadow pricing. It is in fact a rather poor example. Shadow prices were formulated to impound unseen production costs (i.e., externalities, usually of the measurable negative sort), add them to the visible cost of the producer and to tax them accordingly. It is a core tenet of cost-benefit analysis and other kindred utilitarian methods.
Your stylized comparison of change in yields in the UK gilts market with those in periphery EA sovereign bond markets (or the US Treasury or the JGB market) in recent years does not show us anything like the shadow price. That higher yields in the UK are a truer expression of lack of fiscal runway than elsewhere and that if not for risk compression by central bank asset purchases we would be seeing the same thing elsewhere is not beyond contestation. It may well be true but you would have to try harder to convince us. And whether the weak JPY is the result of uncovered interest arbitrage as a result of capped JGB yields is another tall claim that needs further proof.
Finally, talking about impoundment…I was amused by your impounding the word “demeaned” (a couple of days ago) to describe the z-score for a time series. I would have thought most readers of your posts did not need to given a definition of that third moment; by doing so in the way you did, you not only demeaned our intelligence but you also demeaned the English language.
So if as you claimed, we’re in the early stages of a government debt crisis, the size of the problem outside of the UK is being concealed by pathological subsidies. And prices are being prevented from giving the correct information to a great many people. So as the debt crisis gets worse the pressure will be on to increase these subsidies? So on that analysis Japan with its national debt of 240% of GDP will really see currency crisis of some sort? Ian