The New Normal?
We know that interest rates are going to go up eventually. But no-one wants the cost of borrowing to go up right now - least of all the world's overextended governments.
That's why the ructions in the US government bond market this week has people nervous. The interest rate - yield - on a 10 year US treasury bond is now about half a percentage point higher than it was a week ago, and higher than it's been in six months. UK bond yields have risen as well.
There's no point over-analysing a few days' moves in bond markets. Just as you perfect your explanation, investors have a way of turning around to do something different. What matters is the long-term trend.
But the rise in bond yields in the US does flag up two core features of today's misty landscape that will be with us for some time.
The first is that central banks need to handle optimism with care. If you are Ben Bernanke - or Mervyn King - you want to sound confident that policy is on the right track. But you can't sound so confident that people start to expect rates to go up.
This week's rise in bond yields, by itself, doesn't "threaten to stifle the US economic recovery", as one FT headline writer suggested this morning. We don't even know there's a US recovery to stifle yet. But this is certainly an inconvenient time for a sustained rise in long-term borrowing costs.
If yields rise further - and stay there - you can bet that the Federal Reserve will be thinking of ways to push them back down again, perhaps by sending more concrete signals about how long they expect to keep official rates near zero. In the past, Mervyn King has been less keen on that approach because he thinks it limits your room for manoeuvre. (Also, the Bank of England has an inflation target to focus expectations, which the US does not.) But he, too, will want to make sure that higher long-term rates don't get in the way of recovery.
But the second lesson is more fundamental: we all have higher interest rates in our future. And when I say higher, I don't just mean higher than the record lows they are at today, I mean higher than they were before the crunch. An era of cheap money partly got us into this mess. Thanks to the mountain of public debt now sitting on government balance sheets, it's a fair bet that money is going to more expensive when we come out the other side.
Christian Broda at Barclays Capital has run the numbers. As he reminds us, the financial crisis has generated a "scrambling for public funds of war-like proportions".
This chart (from Barclays Capital's Global Economics Weekly) shows the expected cumulative change in the level of public debt as a share of GDP in the US, UK and Eurozone just since 2007. The rise is stunning and, as Broda notes, quite likely optimistic.
Other things equal, basic economic theory suggests that a rise in government borrowing on that scale will push up the long-term cost of borrowing once the recovery gets going. Of course, that might not happen overnight, especially with so much slack in the big economies due to the recession. But even sceptics about the effect of borrowing on rates would probably accept that this kind of rise in government debt will have an effect on the cost of debt.
Looking at a range of studies and different ways to measure the impact, Broda concludes that the rise in government debt, by itself, could raise the yield on 10 year government bonds by 1.5-2.5 percentage points. That could push UK 10 year rates to more than 6% by 2011, solely due to the rise in government debt.
These are very rough estimates, and they're open to debate. In the US, especially, the link between higher borrowing and higher rates has been shaky, at best. Indeed, it was the "conundrum" of low bond yields, despite high public and private borrowing, that partly got us into this mess in the first place. Bond yields stayed low in the lead-up to this crisis, even when standard economic theory would have suggested they should rise.
We could face that conundrum again if global growth is as imbalanced as it was in the past. I'll have more on that tomorrow. But the Barclays Capital study is right about one thing. When the advanced economies pull out of this crisis, the level of public debt is going to be the central fact of economic and political life for years to come.