Politicians propose spending and revenue plans, but the bond market often disposes of them, and not always kindly. In the UK plans to use borrowed money to combine tax reforms that work gradually with an immediate huge increase in the subsidised consumption of energy, were apparently a step too far, both for lenders to his majesty’s government and for the governing party.
Yet long-term interest rates in the US and Europe have also risen rapidly. In Germany 10-year money-yielding negative rates in January had increased to 2% per annum by October. US Treasury bonds that offered 1% per annum in early January now yield more than 4%, and indeed offer more interest in dollars than much-battered 10-year gilts.
Blaming all of this wealth destruction on a potentially profligate UK government is further complicated by not only nominal interest rates going on the rise — real rates did as well. Real 10-year yields in the US are now close to 2% per annum from -1% in January. They exceed the returns on a UK 10-year inflation linker that has increased from -3% in early 2022 to 0%. Equivalent inflation-protected German bunds now offer about 0%, compared to -2% early in 2022.
It is the real cost of funding developed-government debt that has been driven higher in 2022 — not expectations of higher inflation, which would have found expression in higher interest rates for inflation-exposed lenders, not necessarily in higher real yields. Expected inflation, measured as the difference in nominal and real yields for equivalent bonds, has not increased this year in the US, UK or Europe. Expected inflation in the UK over the next 10 years has remained about 4% this year, higher than in Germany and the US, which have varied about the 2.5% rate.
It is not easy to explain why real interest rates in the developed world have risen so significantly. Additional competing demands for capital to fund expenditure that might ordinarily help explain higher costs of capital and rewards for savers have been notably absent. An alternative explanation is that greater risks to lenders have forced yields higher and bond prices lower to compensate lenders. More risk demands higher returns and forces bond values lower.
The risks posed by central banks struggling to cope with inflation have made bond markets far more volatile. The negative correlation between the increases in the US bond market volatility index and the Global Bond index is strikingly large in 2022. The link between increased volatility and lower bond and equity valuations seems relevant. If it is the risk of central bank policy errors that has driven up required returns it may be hoped that a more predictable Federal Reserve (Fed) will be accompanied by lower government bond yields.
Thanks to the inflation-panicked Fed, government bonds have proved anything but a safe haven for pension and retirement funds in the developed world. But in high-yield, high-risk SA bonds have performed far better than equities for pension and retirement funds. The increase in long bond yields has been offset by far higher initial yields, leaving the bond market total return indices unchanged year to date in rand, while the JSE Swix index has cost investors about 4%. RSA 10-year nominal yields started 2022 at 9.73% and have risen to 11.5%, while the real yield on inflation protected bonds is up from 3.63% to 4.6% per annum.
These high yields mean expensive debt for SA taxpayers and offer high-risk premiums to compensate for what has been a seriously deteriorating fiscal stance since 2010. Wednesday’s medium-term budget policy statement represents a serious attempt to regain fiscal sustainability. If the plans are realised, SA’s debt to GDP ratio will decline to well below that of the US or UK.
A primary budget surplus — revenues exceeding all but interest expenses — is unexpectedly in sight. Achieving this would surely represent fiscal sustainability and help bring SA bond yields closer to those of developed market borrowers.
• Kantor is head of the research institute at Investec Wealth & Investment. He writes in his personal capacity.
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