Markets wrong, says Osborne

It’s being reported that George Osborne is planning to issue 100-year gilts or even perpetual gilts in order to “lock in today's low borrowing rates.” From several perspectives, this makes no sense.

Put it this way. If the government issues a perpetual, it could “lock in” a borrowing cost of at 3.8% per year (the current yield on War Loan). But why pay 3.8% when it could issue a five year gilt and pay 1.06%? 

The answer’s simple. Borrowing costs are expected to rise, so that when the five year gilt matures, the government will have to pay a higher interest rate.

But the total cost of a perpetual should be the same as a five year gilt, rolled over indefinitely. This is because the cost of borrowing to the tax-payer is just another way of saying the expected return to the investor. Investors should, in theory, expect the same returns on a perpetual as on five year gilts, rolled over; if they expected higher returns on the perp, they’d all buy the perp and none would buy the five year. Prices should adjust so that total expected returns on gilts of all maturities are the same. Which means total borrowing costs are the same. This is what the expectations theory of the yield curve predicts.

This has, in effect, been the view of the DMO for several years. It has tended to issue gilts fairly evenly across the curve, consistent with the theory that borrowing costs are the same for all maturities.

Now, you might object here that the expectations theory is wrong. You’d be right. But the ways in which it is wrong suggest that Osborne is even more wrong. I’m thinking of two things:

1. The “preferred habitat” view of the yield curve. This says that the expectations theory fails, because it assumes that bonds of any maturity are perfect substitutes for each other. But this is not necessarily the case. A pension fund wishing to match long-term liabilities prefers long-dated gilts, whilst banks wanting liquid assets prefer short-dated ones.

This theory, though, says that the government should issue short-dated gilts, because yields on these are lower, implying that demand is greater.

2. Mistaken expectations. History shows that the expectations theory is wrong, because an upward-sloping yield curve, such as we have now, does not reliably lead to gilt yields rising; this is consistent with the US’s evidence (pdf) over quite long periods (pdf).

But this too suggests Osborne should issue short-dated gilts, as it suggests that borrowing costs might not rise as much as the expectations theory implies.

All this poses the question: why, then, might Osborne want to issue long?

There’s only one good possibility. It’s that Osborne fears that market expectations are wrong in the opposite direction from what they have often been in the past, and that he believes gilt yields will rise even more than the expectations hypothesis implies. In other words, he expects the cost of government borrowing to rise even more than investors expect. It is this - and only this - that justifies “locking in” today’s low rates.

But there’s a problem here. In announcing this, he has set the gilt market wondering whether he knows something they don’t. As a result, gilt prices have fallen. And in this sense, Osborne has increased the costs of government borrowing .  

Comments

[Niklas Smith]

One point you don't mention is that long-dated gilt rates should also include a liquidity premium for investors for two reasons: 1) they don't get their principal back for 100 years, compared with 5 or 10 years for popular gilts and 2) the secondary market for long-dated gilts is less liquid than that for short-dated gilts, meaning that trading costs are higher.

There is of course one good reason for a sovereign to issue long-dated bonds despite having to pay more interest than on short-term bonds rolled over: that having a lot of debt to roll over increases the risk of a failed auction or the market suddenly turning against the DMO in a crisis.

Indeed, you could argue that the portion of government debt issuance that goes into investment in infrastructure and buildings should have the same duration as the economic life of these investments - why should sovereigns take on maturity mismatch risks?

P.S. I would love to know why perpetual bonds were the main form of UK government borrowing from the mid-18th to early 20th century. What were the advantages of consols and why are they not issued any more?

[Keith]

I assume, but do not know, that Gilts used to be owned directly before the twentieth Century by private citizens who welcomed a certain income year by year from consoles or railway debentures etc. Now gilts are mainly held and traded by massive financial firms who thus do not care about income certainty as they hold massive stocks of Debt and buy and sell all the time. If there is a huge secondary market and it is easy to buy and sell cheaply as you are a massive firm then liquidity should be irrelevant to you as the market always provides liquidity. The repayment date on the face of the paper may be ten decades away but you can sell now today for a small discount to who ever will buy it. So the state has no reason to offer one kind of gilt rather than another; so long as the timing of repayments is spread over time to minimise the danger of a refusal to buy new debt in a hypothetical crisis of confidence in the state. But in fact the Treasury would usually just offer higher rates on new debt to tempt the buyers to part with their money. It has always worked before. The credit of the British state has out lasted Napoleon, the kaiser and Adolf Hitler.

[Luke]

Adding on to Niklas Smith's question, is there some positive benefit in having a liquid market in very long dated or perpetual gilts (I am assuming that War Loan is difficult for large investors to buy in quantities they might want). I have no idea, I just wonder if there's something. Indication of long term market expectations?

If not, the risk that such discussions might lead to higher rates seems an obvious one, particularly when there are already 2060 gilts in the market. Those pretty much do the job of locking in low rate for a long time.

[Gareth]

Gilt yields reflect market interest rate expectations PLUS OR MINUS A RISK PREMIUM.

The bond markets repriced UK gilts in the second half of 2011. The movement in ultra-long/perp yields is particularly significant since that part of the curve had previously remained with "normal" nominal GDP growth, yields at around 4.5%-5%.

The government may think this repricing of the risk premium is a temporary revaluation triggered by the Eurozone sh*tstorm; which made gilts relatively more attractive. They may also believe that repricing will reverse in time.

Those are perfectly reasonable positions, and nothing to do with whether Osborne thinks the markets are "wrong" about interest rates.

Did Osborne also "cause" Germany and US bonds to fall in price today? He is more influential than I thought.

[Jon]

I think there's probably another motivation you don't cover - a political one, not economic. Even if the scheme is badly justified and far-fetched, talking about 'locking in' record low interest rates is a great political tool for news management. You get to send a bunch of Treasury ministers out to talk about how you've got record low interest rates. And low borrowing costs are really the only good news there is to talk about. I think the fact this initiative was publicised on the same day as the unemployment numbers came out is certainly no coincidence.

Coalition media strategy at the moment seems to be to bury bad economic news to whatever extent it is possible and for as long as possible - and they've been quite effective at it. I wonder which world leader Cameron will visit for next month's unemployment figures.

[Keith]

" I wonder which world leader Cameron will visit for next month's unemployment figures."

So looks like Cameron is the new Blair with his news management then!

[guthrie]

He's a tory, he wants the price of government borrowing to increase so as to dissaude the government from borrowing and spending on the poor, who don't deserve any help, or public servants, who are being sold off as quickly as possible. But on the other hand he wants some cheap money now to tide his government over.

[BG]

As has been pointed out, one of the main reasons is likely to be that while in expectation (under some particular risk adjusted distribution) it should be neutral to borrow at any point on the yield curve, it only really makes sense to think about your liabilities like this if you run no risk at all, or have the same risk profile as the average investor say.
It's not clear that it is the case for the government. It's conceivable that its utility function is differnet from that of investors. Maybe the fact that you don't have to roll over your debt is a very positive feature of a country's funding profile, in which case it makes sense to issue long dated liabilities and pay a premium to do so.