19th February 2010 by Shaun Richards
After last night’s move in the Discount rate by the Federal Reserve in America I thought that I would look at rising interest rates generally. And I wish to ignore the official ones set by governments and Central Banks as they are short- term (usually overnight). This is because longer-term interest rates are important too and they are much more rarely discussed.
Longer-term interest rates and for this I intend to use ten-year government bond yields as an indicator have in general been falling over the past 20 years or so. I remember for example long-term UK government bonds yielding 15% whereas they now yield less than a third of that. This has been a big boost to economic growth over this period. This has meant many types of borrowing have been made cheaper. Particular examples of this are fixed-rate mortgages which have become more common over this period and also corporate borrowing which is often priced in relation to government bond yields. So the economy has had a nice boost from this. Consumers and corporates have been able to borrow more cheaply. How much of the economic growth of the last twenty years has been caused by this is difficult to measure exactly but it has clearly been a factor.
What is the importance of this?
The importance of this is that this downward trend is turning. This is part of what has been called the sovereign debt crisis. Now if lower longer-term interest rates benefit economic growth then rising ones will harm it. So if this trend continues and I think it will then our efforts to reduce our debt burden will carry an increasing amount of deadweight in terms on interest costs. These are low at the moment (which generates complacency in many quarters) but the trend is rising now.
I have written many articles on Greece and have a category for her. In my view Europe did her no favours by producing plenty of hot air and little detail on what economic assistance they may provide. As I feared after this non-event her ten-year government bond yields have resumed a rising trend and are now 6.57% which is +3.33% over Germany’s ten-year bund. Think of the impact on Greece’s economic growth of long-term interest rates being virtually double what they were a year or two ago.
It has been ignored by many economists (mostly I believe because having read their output they do not understand it) but this effect has also begun in the UK. When I wrote on the Pre-Budget Report on the 10th December 2009 I wrote the following.
As of last nights close if you take the redemption yield on a 10 year government bond it is around 3.7%
Since then it has risen to close last night at 4.2% and we are now at +0.96% when compared with the German ten-year bund rather than +0.52%. Now we have to pay for this as we issue new government debt to finance our fiscal deficit and to replace maturing existing debt.According to the Debt Management office will mean we will have to issue some £225.1 billion this year.So we will have to pay more interest if these levels remain. But just as importantly the rise in longer-term interest rates will damage our economic growth prospects.
This is something that if you look for articles on it is almost invisible. But it is there and whilst a rise of 0.5% is not of disaster size it looks to me as if that is the beginning of a trend and if we can we want to avoid what happened with Greece where things also built slowly and then escalated. For such a move would seriously affect our economic growth prospects just when we will desperately need as much growth as possible.
As this is a slow moving factor and because it is not well understood it is often ignored. This is a mistake because it has benefitted us over the past twenty years and we need to realise this and act accordingly. If last nights move by the Fed is the beginning of a tightening strategy then it may well go down in history books as a turn in long-term interest rates as well as short-term ones.