The Real Puzzle Is the Yield Curve in Gilts

by: Firat Ünlü

Paul Krugman got a lively discussion started with his blog post asking why interest rates on Japanese and Italy bonds were so different. At around 4.5% for ten-year bonds, the spread is huge.

Personally, I am at a loss to comprehend why people would compare Japan and Italy and why this question even arises. As should be known by now the Japanese economy is fundamentally structured differently. As in most of East Asia, the relationship between government, big business and bureaucrats is tight-knit. Whereas banks in Italy are supposed to help in price-discovery, that is not exactly true for Japan. Traditionally the role of the interest rate has been neglected in East Asian bank lending; companies had access to cheap funds in order to finance their operations much more competitively.

Other notable examples are Korean chaebols (big conglomerates) or Chinese SOEs. Many investors and hedge funds have been burned in shorting Japanese government bonds because they misunderstood how banks would behave. On paper it sounds like an easy trade, government debt in excess of 200% and one third of total revenue goes towards interest payments alone, not to mention the demographics.

Bank lending in East Asia is often based on policy criteria, and what could be more important than preventing national default and helping the government- and in extension the nation- over a difficult period? Korean citizens were donating gold to their government to help deal with the aftermath of the Asian Financial Crisis. In such an environment it is simply inconceivable that banks would stop recycling private savings into government bonds. Whilst there are many other variables such as deflation and currency appreciation that have helped keep a lid on higher yields, this explanation helps understand why savings continue to be funneled into this area.

It is not Japan that is puzzling but the U.K. Inflation has been above the Bank of England target rate of 2% for 51 of the past 60 months and hovers between four and five percent at the moment. Yet gilts aren’t all that far away for their all-time 1740 low of 2.5%. What is happening in the U.K? How can this yield curve be explained?

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.