Well, the action seems to be hotting up. The story so far: long term bond rates of the UK and US have
become closely related, and guess which one is the tail (UK) and which one the
dog (the US). Both long term rates have
recently been hovering over the German rate which is around 0.5-1% lower. Currently, the UK/US 10 year yields are near
identical at around 2.75%, whilst the German rate is a little under 2%. The trend is upwards: in early May (before
Bernake’s “Tapering” announcement to Congress), the same rates were US/UK 1.6%
and Germany 1.3%. Hence we have a simple
story. Germany can be seen as the
reference point. The US and UK have
higher rates, reflecting “inflation risk”.
With all of the QE going on markets believe that there is clearly much
more of a risk of inflation over the next decade. Also, the Germans seem to be
keeping as hard a grip as possible on the expansionist tendencies of super
Mario at the ECB. France also has higher
long rates than Germany: this could stem from a combination of “Euro break-up”
risk (any post-breakup French currency
would devalue against the new DM) with default risk.

Now, back to Bernanke on the 22nd May announcing
the possibility of tapering commencing soon: well now in fact. QE, which has meant the Fed buying up lots of
the US national debt has kept US government bond prices high, and hence the
long rate low. Stopping buying up
government bonds can have only one effect: bond prices fall, and long term
interest rates rise. But, of course, the
markets are forward looking. If prices are going to fall in a few months,
people will start to change their positions and hold less of the bonds, leading
to rise in interest rates well before any tapering has actually happened. The BBC has been following this, particularly
in relation to the effect on emerging markets. The prospect of rising US
interest rates has led to money flowing out of emerging markets, reversing the
flow caused by QE pushing investors onto emerging markets in search of “higher

But of course, the effect will not just be on emerging
markets. If we leave aside the Eurozone for the moment, which has its own
special dynamic, the UK will be affected by this too. Enter Mark Carney, with his forward guidance
in July. No tapering in prospect, with long-term interest rates to be kept low
if necessary with more QE (oh, with a long list of conditions of course, but
let’s stick to the main story). Well,
is it possible for the UK to have substantially lower interest rates than the
US? Well, of course it is possible: however, it will have consequences. Let’s see how the markets reacted. After the Forward Guidance, markets seemed to
give Mr Carney some credibility: UK 10
year rates fell below US rates, about 20 basis points and remained below until
late August. Now they are back
together. Well, markets realised that
the Bank of England will not be able to have lower rates than the US for
long. The consequences would be a
devaluation of sterling, which would almost certainly lead to more
inflation. The recent experience of
Sterling’s devaluation against the Dollar would indicate that a large part of
it would pass through into inflation over 2-3 years. Since inflation is currently well above target,
devaluation would be most unwelcome. And
of course, one of Carney’s caveats referred to interest rates having to respond
if inflation became too high.

So, what is the take home for economists? Well, the most
unnatural state of affairs with low interest rates is a bit of a Prisoner’s dilemma.
Most of the developed world needs to
follow the policy of “repressed inflation” , the key feature being sustained
negative real interest rates to help with public finances and reduce the growth
in debt-GDP ratios. However, as in the Prisoner’s
dilemma, they can only do this if they stick together. If one of the main players (The US, the ECB,
BOJ, maybe even plucky little BoE) decides to break and offer higher interest
rates, funds will flow to it. In order
to keep savers and investors in thrall to negative real returns, they need to
have no safe alternative. Emerging
markets may look attractive but are subject to lots of “other” risk (politics,
potential crises etc.). If the US is
going to offer more attractive interest rates, it will be hard for the Bank of
England to persuade investors to buy British bonds. Of course, a devaluation against the Dollar
might be attractive for some countries: Japan for one might be quite happy as
this will help them generate some of the inflation they want to create. But not the UK. Forget forward guidance? Maybe the markets
already have. Or maybe Mark Carney has something up his sleeve….let’s see how
this continues to evolve over the coming months as tapering (probably) becomes
a reality…Isn’t economics exciting: you never know quite what is going to
happen next…