For many readers, what happens to gilt yields may seem somewhat arcane. Yet they are a critical variable. They affect us in three major ways. First, they are the yardstick for the valuation of all sorts of assets, including equities and property. For the latter, it is 10-year yields that are most often used.
Second, they affect the terms of borrowing for just about everyone, including companies and households. For households, the effect is most acute in relation to fixed-rate mortgages. And in that regard it is two and five-year yields that matter most.
Third, gilt yields determine the cost of government borrowing, as well as the cost of refinancing existing debt.
So what drives gilt yields? It is widely believed that the key variable is the amount of government borrowing, which determines the amount of gilts issued. After all, other things equal, when supply increases you would expect the price of bonds to fall, which then increases their yield. And there is something in this, although when the economic conditions are right, the bond markets may absorb almost unlimited quantities of government debt without turning a hair.
Most importantly, on many occasions other things are not equal. During the pandemic, for instance, government borrowing shot up to 15pc of GDP. Yet gilt yields fell to record lows.
The second major influence is the level of official short-term interest rates, which is set by the Bank of England. The influence of the current rate, presently at 4.75pc, is felt most strongly on short maturities. The further you get away from short-term maturities, then the smaller is the influence of the current rate and the greater the influence of expectations about future rates.
This brings us to the third major influence, namely inflation. Here too, it is not the current inflation rate that the markets focus on but rather the rate that they expect over the life of the bond. Current rates are only relevant in so far as they influence those expectations.
In this regard, last week’s data releases were less than helpful. Inflation rose from 1.7pc to 2.3pc, compared with an expectation in the markets of something like 2.1pc. It now looks as though by January inflation may be about 3pc.