What are gilts saying?

In his Autumn Statement George Osborne said that the UK government is now “borrowing more cheaply than Germany" and (par 1.39) “there is evidence that the Government’s fiscal plans are contributing to improved market confidence, with UK long-term interest rates reaching a record low*.

This, though, runs into a problem. Low gilts yields - either in absolute terms or relative to overseas - are, in themselves, an ambiguous sign. Yes, they might signal confidence in the government’s creditworthiness.  But they might also signal that the economy is weak. How can we adjudicate between these interpretations?

One way is to look at share prices. If gilt yields fall because of better creditworthiness, share prices should rise as investors attach a lower probability to the risk of a debt crisis which causes capital flight and enforced austerity. But if gilt yields drop because of a weak economy, shares should suffer.

My chart tries to adjudicate between these two possibilities. It shows the FTSE small cap index (chosen because small caps are more exposed to the UK economy than the FTSE 100 which is dominated by multinationals) relative to MSCI’s world index in sterling, which controls for global influences upon equity prices.

This chart is wonderfully ambiguous.

Tories can point to the rise in small caps relative to the world between May 2010 and this summer as a sign that the fall in gilt yields (from 3.8 to 2.5 per cent for 10 year ones) was accompanied by increased confidence in the UK economy - or, at least, reduced fear of a debt crisis.

However, Labourites can point to the drop in small caps since then as a sign that lower gilt yields are a sign of depressed economic confidence.

I’d stress that, in both cases, the moves are small; if I’d started my chart earlier, the last 18 months would look like a horizontal line.

The only message I’d take from this is that political disputes are rarely settled by the facts.

* I’m not sure this is strictly true. Yields on 2.5% Consols, for which we have the longest history, are now 3.68%, which is higher than they were between 1934 and 1950 or in the 40 years before World War I.

Comments

[Matthew]

Doesn't QE have something to do with as well?

[Adam]

I hear a lot of people say that low yields might be either credit-worthiness or economic stagnation. It's the wrong way to think about it.

The right way is that it's a sign of relative credit worthiness (to other investment oppertunities). If other oppertunities have got more risky i.e. because of a recession, other things being equal bond yields will fall.

It doesn't really matter what's happened: Britain's relative credit worthiness has gone up. Yes it might have happened anyway, but so what?

[chris]

QE1 stopped in early 2010. It's not obvious that it would therefore have reduced yields and raised share prices from May 2010 to the summer of 2011.
Nor is it obvious that QE should depress gilt yields. Yes, direct buying of gilts does so. But if QE works in reducing tail risk or increasing growth/inflation expectations,gilt yields should tend to rise, as should share prices. It's only because the latter effects are weak that QE does reduce yields net.

[Matthew]

QE has restarted, so should be exerting downwards pressure again, but I think the issue is why they are lower than Germany, and the Bank being a large holder must help even when QE is not taking place.

I don't think I agree with the last point - it's too much like the argument you here that lower oil prices caused by a collapse in growth can boost growth. The Bank thinks gilt yields fell in response to QE.

[Elisydulce]

check Mahina Leather for more detail for less