Tuesday, 11 June 2013

My Word! My Bonds!

The early signs of recovery were visible in December but after a few months of bumping along the bottom we now have some more consistent evidence that the economy is moving forwards, rather than sideways.  Our service sector (63% of the economy) is leading the way and even construction (7%) and manufacturing (11%) are making a contribution.  The problem of indebtedness still overhangs us like a thunder cloud threatening to rain on our parade.  The overall level of debt is frightening in itself (over 300% of GDP if we include all government and private debt)  but it’s the possibility of rising inflation and interest rates that really terrifies commentators.  At a 0.5% base rate we can certainly manage the problem at base rates of 5% things will be very different.  The one certainty is that rates will rise in the medium term – and this one-way bet is now reflected in an increasingly jittery bond market. 
Weaning ourselves off negative real interest rates is going to be painful but the earlier we start the more manageable the pain will be.  If we remain in the cloud-cuckoo land of negative real interest rates we will be at the whim of the markets but if we can be brave and set our own agenda we might well become a safe haven for a global bond market in distress.  At some point bond prices will start to fall and yields and interest rates will rise, the tipping point is not far off and fickle markets could turn this natural evolution into a full blown bear market for bonds, with an unprecedented sell off which would drive up interest rates dramatically.  Britain has one small advantage in that we are emerging from recession about a year in front of the Eurozone our main export market and we are better placed to deal with some increase in interest rates that our main competition. By implementing a small increase in interest rates now we could secure low interest rates of the longer term as the bond market doubt about the level of sovereign debt mount.
There are obvious risks to this approach, would marginally higher interest rates slow economic activity and therefore drive up government expenditure on benefits?  Also the treat to Sterling and the impact of reduced imports but this would be countered by the deflationary impact on imports.  These are serious concern but the pale into insignificance when weighed against the more cataclysmic option of being at the mercy of a dying bond market

The arrival of Mark Carney at the Bank of England gives us an excuse the look afresh at our options and I hope he will be brave and take a contrarian view of the world and our place in it. 
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