The Importance of the Bond Market

I used to think if there was reincarnation, I wanted to come back as the President or the Pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everyone.

--James Carville, Clinton campaign strategist

In the 1990s, President Clinton tried to increase the US budget deficit, this led to a sell off of Government bonds, causing the Clinton administration to alter policy - instead of an increasing budget deficit, Clinton managed a rare budget surplus. This is an example of how bond markets can be very poweful.

The Bond market generally refers to the Government bond market, though there are also bond markets for corporate bonds and financial instruments like mortgage bonds. On the surface, bond markets look pretty uninteresting. Most people will have only a partial understanding of how they work and the impact they can have. Yet, below the surface of their respectability and anonymity, bond markets have the power to change government policy, and even change governments.

"I don't care a damn about stocks and bonds, but I don't want to see them go down the first day I am President."

- Theodore Roosevelt

Why The Bond Market is Important

Governments need to borrow money. They borrow money through selling bonds to the private sector. Usually, investors are quite happy to buy government bonds. They are seen as a safe investment (governments usually don't default) and the investor gets a guaranteed rate of interest in return.

Fear of Default

The problem with bond markets comes at the first sign of possible debt default.

If the bond market feels the government is borrowing beyond it's capacity. There is a chance that the government will not be able to repay its debt. The government may then create inflation to be able to pay back the debt. This reduces the value of bonds.

If there is a greater fear of debt default or default via inflation, then investors will require a higher interest payment to compensate for the risk.

Investors will send bonds, causing the price of bonds to fall and therefore the effective interest rate to rise.

The greater the chance of default, the higher the interest rate markets will require. This is why credit ratings can be very important. A downgrade in a countries credit rating from AAA to BBB means it is more difficult and more expensive to borrow.

This is very important for the government. Through the DMO, the government needs to sell something like £180bn of gilts and bonds this year. At the moment, the government can pay a relatively low interest rate on these gilts, because the bond market has the appetite to buy them.

However, if the markets lost confidence, in the governments fiscal position, bond prices would fall and the government would have to pay higher interest rates. When you have a national debt of £800bn, a 0.5% rise in interest rates is still a significant sum.

Often the fear of higher interest rates due to borrowing is exaggerated. So far, the government have been able to borrow as much as they need at relatively low interest rates. Japan is borrowing close to 200% of GDP and it hasn't spooked the bond market (yet).

But, the point is the bond market has the capacity to throw the governments best laid plans into confusion. There is no fixed level of debt when bond markets will turn. It doesn't just depend on levels of debt, but, issues such as political stability, expectations of future e.t.c

If the bond market froze up, it could force the government into painful choices. - Cut spending, increase taxes. It can be brutal.

Further Reading

• The Bond Market and the Financial Crisis
• Bond Market and the Relationship between bond prices and interest rates
• Impact of Rising Bond Yields