Deficits, gilts and the cost of living: more myth busting

Retaining objectivity and balance in my commentary on accepted norms in financial markets and economics is getting more and more difficult these days. The problem I find is that an increasing number of official doctrines frequently espoused and accepted by the media and politicians are patently not true. Whilst this may not be the most pressing problem confronting us all, I worry that this will become a much bigger and more dangerous issue.

It’s hard enough for policy makers to make the right decisions given the many uncertainties they confront, but their challenge will become even greater if they fail to base those decisions on available facts and instead rely on an increasingly worrying set of media-generated myths.

I have written about some of these myths in recent months, including those surrounding the politically charged wealth and income inequality debate, food retailer price gouging, the cost-of-living crisis, and the current hissy fit in the bond market, which the Telegraph described this week as a “bond market rout of epic proportions”. In the same article, Jeremy Warner goes on to suggest that “we have entered a new inflationary age”.

Unlike the other issues, this is an opinion, and one which I will argue against in a future note, but before doing so I just wanted to put a few more facts in front of Noise Cancelling readers which will address two of the myths above – namely the cost-of-living crisis and the bond market issues. I will also wrap into that the frequently cited gilt market buyers’ strike/stress/panic narrative, which is yet another media favourite.

The TelegraphThe US government is now as risky an investment as AIThis epic bond market rout shows investors are losing confidence in countries’ ability to repay their debts

The cost-of-living crisis

So first to the cost-of-living crisis. In More splinters, planks and myth busting, which was published last week, I presented some data (from the ONS) which showed that since the pandemic struck in February 2020, consumer prices have risen by a cumulative 31% but that average earnings (before tax) had risen by 38%.

Many might wish that the gap between these two numbers was even bigger, but the fact is that the notion of a growing cost-of-living crisis in the UK, alive and kicking in the minds of most politicians and of course in the media too, is not true. I suggested in the narrative that accompanied a chart in that piece that on a post-tax basis the gap would be even bigger, and it is, although not by that much.

So, before tax, as I have said, average earnings have increased by 38.1% but, after the negative effect of a frozen personal allowance being more than offset by a big reduction in employees’ national insurance, post-tax earnings have increased by 39.1%.

Last week’s data, in fullMore splinters, planks and myth bustingSlowing private sector pay, mythical price gouging and a cost of living crisis that isn't – what yesterday's labour market data actually reveals.18 August 2026→

So, prices up 31%, average post-tax earnings up 39.1% since February 2020. The facts objectively do not correlate with a growing cost-of-living crisis narrative for those on average earnings. (For the record, lower-income cohorts have seen faster growth in pre- and post-tax earnings than those on average earnings over this period.)

Although it’s too complicated and almost impossible to work out, at least for me, given real-terms increases in in-work benefits seen over this period, for those on average earnings who are lucky enough to qualify for them there is an even bigger gap between “costs” and post-tax incomes for this group too (see my Inequality note published a few weeks ago).

The deficit myth in the Treasury market

Now to the bond market myths currently doing the rounds. The first one concerns the Treasury market. A number of commentators in the financial media are suggesting that recent weakness across longer maturities is an unequivocal sign of a “market rout” and stress related to investor concerns about the scale of the US deficit and total government debt. Here are a couple of long-term charts tracing the history of the US government deficit, in absolute terms and as a percentage of GDP.

I wanted to show these two charts to slay one of the most common myths about government borrowing, and that is, in short, that there is some kind of fixed, close relationship between the amount of money the US government is borrowing and the interest rate it must pay for that borrowing.

On the face of it, it sounds sensible, but when the long-run history is run, the truth is revealed. There is no observed relationship between these two variables. If there were, how could you explain the fact that when the US government borrowed just over 14.5% of GDP in 2020 during the pandemic, it did so when ten-year bond yields were at record lows of less than 1%? (By the way, the UK experience was exactly the same.)

Possibly even more persuasively, how could you explain the fact that when the budget was in surplus in 2000, ten-year bond yields were at 6.7%? (In January 2000.)

What actually drives bond yields

In short, this commonly held perception is wrong. The truth is that, just as in the UK, ten-year yields – and indeed yields across the maturity curve – are driven by what’s happening to inflation, which in turn drives the Fed’s interest-rate-setting decisions, which in turn dictate what’s happening to Treasury yields. Here are the charts that demonstrate this long-run relationship, in the US and in the UK.

And finally, for those more mathematically minded, here is a chart mapping the relationship between the Fed funds rate and the ten-year bond yield. The R-squared of 0.81 shows a very strong linear relationship between the independent variable (the Fed funds rate – x-axis) and the dependent variable (the ten-year Treasury bond yield – y-axis). Indeed, the R-squared shows that 81% of the variance in the ten-year bond yield is explained by the Fed funds rate.

The deficit, run through the same test

Having shown what drives the ten-year yield, it is only fair to run the identical test on what most commentators think drives it – namely the scale of the deficit. Here is the same scatter, this time mapping the deficit as a percentage of GDP against the average ten-year yield in each fiscal year since 1962.

The R-squared this time is 0.06. The size of the deficit explains around 6% of the variance in the ten-year yield – effectively nothing, leaving 94% explained by something else – and what little relationship exists runs the wrong way for the doom-mongers: bigger deficits have coincided with marginally lower yields, not higher ones. Set the two scatters side by side, and the myth is measured. The Fed funds rate explains 81% of the ten-year yield; the deficit explains 6%.

Japan, incidentally, has run this experiment at scale. Government debt above 200% of GDP coexisted with ten-year yields below 1% – at times below zero – for more than a decade, because inflation and the policy rate were pinned at zero. This year, with the debt ratio actually falling, the ten-year JGB yield has climbed to around 2.8%, its highest for thirty years, because the Bank of Japan has raised rates to 1% in response to inflation running at around 2.5%. The debt went one way; yields went the other. It is not the borrowing that sets the price of money: it is inflation and the central bank.

CNBCBank of Japan hikes rates to 1%, highest since 1995, as yen and inflation worries take holdThis is the BOJ's first hike since December, when it raised rates to its current level of 0.75%, also its highest level in over 30 years.

The gilt “buyers’ strike”

The final myth that I aim to slay with this analysis is that which seems to be particularly popular at the moment with those commentators determined to portray the UK economy as a basket case and the government’s debt position as untenable. Typically, these journalists, and some economic commentators, evidence the ten-year gilt yield, and sometimes the thirty-year yield, as indicative of market stress or, alternatively, of a buyers’ strike.

Once again, it is no such thing. The yield curve in the UK, just as in the US, is similarly dictated by UK inflation and base rates, but with the addition of a very close relationship with US Treasury yields, as the chart below clearly demonstrates.

Interestingly, albeit that the relationship between these two bond markets has been very close for forty years, the premium, and sometimes discount, in UK yields has fluctuated over this period. Right now, the 33bps premium is below the forty-year average of 40bps (see below). One could therefore legitimately argue that stress in the UK gilt market was below normal right now. A million miles from the popular narrative.

What a buyers’ strike actually looks like

We have, after all, seen genuine gilt market stress recently enough that memories should not need refreshing. In September 2022, after the mini-budget, thirty-year gilt yields rose by 140 basis points in three days – the Bank of England’s own description was “historic” – as leveraged pension schemes sold gilts into a falling market to meet collateral calls. The Bank was forced into an emergency intervention, ultimately buying £19.3bn of gilts to break the spiral. That is what stress looks like: forced sellers, a central bank stepping in, and prices moving further in days than they would normally move in a year.

Now compare the present. On 18 August the Debt Management Office sold £4bn of ten-year gilts and received £14.6bn of bids – covered 3.65 times, with accepted bids clustered within a tenth of a basis point of each other. Across the DMO’s last full year, gilt auctions were covered 3.2 times on average, up from 2.8 times the year before. A buyers’ strike produces uncovered auctions and scattered bids. What the gilt market has is a queue.

Summary

So, to recap what’s covered in this slightly odd myth busting note:

• The popular political narrative currently being championed by the new Prime Minister on his listening tour of the UK is that the cost-of-living crisis has been getting worse for hard-working families, and he is listening and ready to do what can be done. Of course, much of this is political theatre and to be expected, but just like the lie that is growing income and wealth inequality in the UK, this is also a lie. The rising cost of living, best represented by the CPI, has lagged significantly behind the growth in post-tax average earnings since February 2020. Those are the facts.
• The weirdly consensual myth that there is some kind of fixed, deterministic relationship between the scale of budget deficits and bond yields in the US and the UK is not true. The bond yields in both markets are determined by inflation (current and forecast) and the level of official interest rates (Fed funds and base rates).
• The popular doom-laden narrative that the UK economy is within a gnat’s whisker of having to go cap in hand to the IMF, because we have reached the limits of our borrowing capacity, is not supported by the facts. There is no stress visible in the UK gilt market represented by a yield premium over its historical benchmark comparator. The comparatively high yields in the long end of the gilt market are driven by relatively elevated levels of inflation (albeit falling this year) and by what I consider to be inappropriately high official interest rates at 3.75%, alongside a long-term close relationship with bond yields in the US.

The Irish NewsBurnham to kick off national tour to hear cost-of-living concernsA spokesperson for the Prime Minister said he would be ‘getting out of Westminster and meeting people where they are’.

One other point to emphasise here is a broader global economic one. Whilst most economic commentators are busy criticising the US economy for the scale of its twin deficits (trade and budget), none seem to acknowledge that without them the world would be in a recession. Whilst the Chinese and European economies are gripped by significant excess saving and subdued consumption growth, someone somewhere has to fulfil the consumer-of-last-resort role, and for the time being that is the US economy.

One final observation, which is where this piece started. I remain more than a little alarmed at the scale of the consensual nonsense that pervades economic and political discourse. As Jack Kennedy observed all those years ago, unchallenged myths become pervasive truths, and that’s when all sorts of stupidity prevail.