Why the US bond market matters to the UK

Try talking to someone about the bond market and their reaction will probably range from eye-rolling to a bad pun involving 007. Bonds, specifically the IOUs issued by companies and governments, tend to kill conversation as readily as bad breath.

But last week something rather interesting happened in the bond market. No, really it did. The interest rate that the US government pays on its ten-year debt fell sharply off the back of some weak economic data. As a result, the US Treasury can now finance its $22tn debt using decade-long IOUs paying an interest rate of just 2.5%. This is a lower interest rate than the IOUs that expire in three months’ time.

When short-term debt becomes more expensive than long term debt this is known as a “yield inversion”. It has happened in the US only four times in the last thirty years and the last three occasions all preceded a US recession. This is why a yield inversion is interesting for investors. It can offer a clue on when to sell risky assets or shift into safer investments. A reliable indicator like this is as rare as hens’ teeth. For investors it can be pure catnip.

Even politicians take note. In the 1990s, the Democratic political adviser James Carville wryly observed “I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a [top] baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.” And investors were, true to form, intimidated as markets slumped on fears that the recent slowdown in the US economy will morph into an outright recession.

But why should this matter? Whilst the US economy remains the world’s biggest, US households and companies buy just 18% of UK exports. This volume is dwarfed by the amount of trade conducted with the European Union. Furthermore, the growth in US-UK trade lags well behind that with emerging markets such as China and India.

But what goes on in the US does matter to each of us. UK pensions and life insurance companies hold 32% of our assets, equivalent to £1.4tn, in shares in overseas companies. If the US economy falls into a recession it is likely that these shares will become less valuable as profits become harder to come by. As an ever-growing proportion of Britons save into a workplace pension – one of the true policy triumphs of UK governments over the last 15 years — the value of that retirement fund is intrinsically linked to the success of the US economy.

But it also matters to households who rely on cash savings. Should the US economy slow sharply this year it is likely that US interest rates will have to be cut. In our interconnected financial markets this means instant access savings accounts in the UK will continue to offer pitiful interest rates. The light at the end of the tunnel for savers risks being extinguished almost as quickly as it appeared.

A word of caution is warranted, however. As investors found to their cost in 2008 the trends of the past are not guaranteed to repeat forever. Treating trends in financial markets like the laws of the physics is a one-way ticket to losing money. Therefore, on London’s trading floors last Friday there was also plenty of scepticism as to whether history is really repeating itself. Central banks across the world have bought government debt worth more than £15tn, driving interest rates ever lower. And while interest rates have recently nudged higher, they are hardly at levels that discourages borrowing — the usual trigger for a recession.

But amid the current diet of wall-to-wall Brexit commentary the US bond market has provided a reminder that the UK economy remains heavily influenced by what goes on beyond our shores. Money, People and Goods continue to move across borders at ever-faster rates.

“Taking Back Control” was effective in dangling the prospect of a UK economy designed and managed in our own image. Recent events in the US bond market remind us that is not the way open economies operate in the 21st century.

A version of this piece appeared in the Evening Standard.

Simon French

Economics & Strategy