Reasons for Falling Bond Yields

The UK has one of the largest budget deficits in the OECD. Often the argument is that if government borrowing rises, this pushes up interest rates. (see: problems of Government borrowing) This has occurred for some countries in the Eurozone, e.g. Ireland, Spain, Portugal, Greece and recently Italy. (see: bond yields on EU debt) Markets fear the fiscal situation and liquidity of these countries and so have become more reluctant to buy Eurozebonds. This causes a fall in price of bonds and rise in interest rates. (see: inverse relationship between bond price and yields).

Yet, the UK, with one of highest budget deficits in Europe, and a rapidly increasing public sector debt, has still seen a significant fall in bond yields.

Recent UK Bond Yields

Source: Bank of England - 10 year bond yields
David Cameron claims that the fall in bond yields is vindication of the governments resolve in pushing through spending cuts to bring down the deficit.

This may have played a small role. But, the main reason bond yields are so low is that we are in a liquidity trap, with strong demand for government bonds due to private investors preferring the security of government bonds to spending, investment or undertaking risky investment. When the UK economy recovers, we will see a rise in bond yields as investors become less attracted to government bonds with a low return.

Reasons for Falling Bond Yields

1. Prospects for Low Growth / Low inflation

• When markets expect low growth and low inflation, they tend to move out of stocks and into bonds.The prolonged recession and poor outlook for 2013 means there is limited demand for buying private sector corporate bonds. Investors prefer the relative security of government bonds.
• In a period of deflation and low return on private sector investment, bond yields of even 1% can offer a better return than cash under the bed.

2. Higher Saving Ratio 

uk-saving-ratio source: ONS

• Since Q1 2008, we have seen a strong rise in the saving ratio as people prefer to pay off debt, increase savings and reduce consumption.  Similarly firms are preferring to hold onto cash reserves rather than undertake risky investment. This is why in a liquidity trap, in a recession, governments can usually borrow more without causing higher interest rates. Demand for bonds is stronger in a recession.

If there was the prospect of higher economic growth, bond yields would tend to rise, as markets anticipated higher interest rates and better returns from the private sector.

3. Quantitative Easing

Quantitative easing has involved the creation of £375bn of new money, which has been  used to  purchase government bonds. The Central Bank buy bonds, pushing up prices and pushing down bond yields. If the Central Bank reversed quantitative easing, we would see a fall in bond prices and increase in bond yields.


Related

• Reasons for rising bond yields
• Falling bond yields in US

Comparison of Government Deficits

Highest budget deficits - Ireland, Japan, UK and US. Data 2010.

10 Year Bond Yields

 

data for 2010

• The link between size of budget deficit and bond yields is very weak.
• Portugal and Spain have very high bond yields despite low borrowing.
• US, Japan and UK have very low bond yields - despite highest levels of government borrowing