Rising gilt yields could signal global turning point

Government bond yields have risen sharply in the past two weeks, signalling a possible turning point for financial markets and an end to easy credit. US Treasury yields have risen to an 18-month high of 4.8% in recent weeks and UK gilt yields are also higher.

Falling bond prices - which mean their fixed interest payments give a rising yield - could finally be responding to central banks' interest rate rises. This could see the cost of popular fixed-rate mortgages increase, which in turn has implications for booming house prices.

The fact that long bond yields remained low when short-term interest rates were rising over the past couple of years had been referred to as a "conundrum" by Alan Greenspan, the former chairman of the US Federal Reserve. The Bank of England had described it as "unhelpful". Many financial commentators around the world simply scratched their heads.

Normally when the Fed, the Bank of England and the European Central Bank raise short-term rates, longer rates, which are set by the market, move up to price in the fact that short rates will be higher in future. But not this time. As global interest rates, particularly in the US and the UK, have risen over the past two years, long rates, or yields, have been either static or, in Britain's case, have fallen.

Until now, that is. Bond yields have risen to their highest for nearly five months in Britain. The markets seem to have taken the recent rate rises from the ECB, hawkish comments from the Fed and talk that the Bank of Japan would soon start to raise its short rate from zero as a sign that world central banks were serious about mopping up the excess liquidity that has sloshed around the world for years. The 10-year British government bond or gilt yield has increased nearly a tenth in just two months to 4.35%. In January, gilt yields on ultra-long bonds (30 years or more) fell to a 50-year low of 3.5%, while the benchmark 10-year gilt dipped below 4% (see graph).

It may be too early to say definitively that Mr Greenspan's "conundrum" has been solved, but the move upwards in world bond yields is significant and could mark a step change upwards in the world cost of capital.

Bond yields affect the lives of most people through pension funds and annuities, and through fixed-rate mortgages, where lenders buy a batch of gilts to offset the cost of the mortgage offering. Businesses are affected through the cost of raising finance for investment or takeovers.

Two-year and five-year fixed mortgage rates fell sharply in the last quarter of 2005, putting upward pressure on house prices at a time when the Bank of England had raised short interest rates, at least in part to slow the great property boom of recent years. Hence its description of falling yields as "unhelpful". Fixed-rate mortgages are almost certain to head higher in the coming weeks, which could suppress house prices once again.

Rising bond yields is good news for UK pension funds, which are required to match their liabilities with assets. Since the calculation is affected by the yield they can obtain on gilt holdings, as yields have fallen, their deficits have widened, obliging them to buy more gilts to cover the gap. This has had the effect of pushing up gilt prices, meaning yields fall further. But rising yields help boost funds' values, encouraging them to buy fewer gilts. That could bring down the price, meaning yields bounce still higher.

Pensioners are also affected since annuity rates are directly connected to gilt yields. After the agony for many who have retired recently and been locked into low annuity rates, the outlook could be improving for those approaching retirement if yields continue their upward march.