Business | Opinion
Gilt yields set to be one of biggest themes to affect markets in 2010
Analysts' outlook reports peppered with caveats about "unprecedented" circumstances
- Financial Times
- Published: 00:00 December 29, 2009
The markets just gave the Bank of England a Christmas present. After a year spent twitching, sometimes wrongly, at the bank's every cough or eyebrow wiggle, the release of the minutes of its latest policy meeting did not even cause a ripple.
But last Wednesday's calm was a temporary holiday-linked reprieve; monetary policy and gilt yields — their level, direction and even shape, are set to be one of the biggest themes to affect all markets next year.
This time last year analysts' outlook reports were peppered with caveats about "unprecedented" circumstances and the consequent "lack of visibility."
This year, there is less grumbling about "visibility" but the "unprecedented conditions" part still holds true in some sense. Last year, no one had the foggiest where or how this year would develop.
This year we know what needs to be done in the next 12 months, but we are still not sure how it will be done and, more importantly, what effect it will have.
The big task is the beginning of normalising monetary policy and taking away some of the extraordinary stimulus that has sustained markets and triggered an almost record stock market rally.
Incredible pain
One camp holds that the stimulus, notably quantitative easing, simply anaesthetised the markets, which, like a trauma victim, needed the relief to cope with what was happening but now face incredible pain as the dope wears off.
There is another view that if the bank gets its timing right, the strain will be bearable for the economy because its (currently tentative) recovery will have taken hold.
Either scenario is pitted with "ifs". In search of something more concrete, many are turning to the gilts market for a collective view — and to find just how quickly their "if"-laced forecasts can come undone.
Currently the yield curve, as measured by the gap between short and long-term bond yields is extremely steep. On Wednesday 10-year gilt yields, up 8 basis points at 3.989 per cent, hit their highest levels since June. This compares to 1.299 per cent for two-year gilts
This steepness is theoretically good for stocks since it implies expectations that interest rates will rise which in itself reflects a belief in healthy economic growth.
Yields all along the curve are expected to rise next year as investors factor in higher interest rates. But the danger is that something causes yields to rocket rather than rise.
This is the territory of bond vigilantes, a phrase coined in the US to cover those periods where vicious, sudden rises in bond yields are the result of a widespread investor fear that either some combination of weak government control, heavy spending or low interest rates (or all three) risk fuelling inflation to dangerous levels.
One such episode, in 1994, forced the Clinton administration to alter its spending plans and led political strategist James Carville (he of the "it's the economy, stupid" quote) to claim that if he were reincarnated, he no longer wanted to be a great baseball hitter, but the bond markets because "then you can intimidate everyone".
The shape of the yield curve, and its level, is complicated by a record-sized wave of supply due next year. This year, much of the government's extra borrowing was soaked up by the bank's quantitative easing purchases, but this is due to end in February.
That leaves a market accustomed to some £40 billion (Dh234 billion) supply facing an expected £225.1 billion of new issues. To put that in perspective, the entire outstanding stock of gilts rose by a total of £220 billion between 1980 and 1997, according to analysts at Barclays Capital.
There is no expectation of an imminent buyers' strike, but it seems likely that supply of this size will come at some extra price. The market worry is exactly how hard a bargain investors will drive.
James Carville coined his economy catchphrase during the 1992 US election campaign — before he knew the damage bond markets can inflict.
With gilt markets already nervous, it's quite possible that the upcoming general election here will get its own version: "It's the bond markets, stupid."
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