UK bond yields - where are they going?

Since early October, the yield on 10 year UK government bonds has crept up 73 basis points. That is equivalent to three typical hikes of the Bank of England's bank rate.

Should we worry? Have financial markets finally realized that the government may have difficulties in repaying the huge amounts of debt it has issued since the financial crisis began?

There are at three reasons for taking a calm and measured approach to rising bond yields:

• Yields were higher earlier this year - In February, the yield hit 4.23; currently the yield stands at 3.69.  Back then the investors were worrying about an election, and the possibility of a renewed Brown mandate.  As the election approached, investors calmed down as New Labour's poll numbers declined.   
• The government has announced a fiscal consolidation plan - The coalition has what appears to be a credible plan to reduce the deficit.  It is also prepared to enact difficult measures, such as hiking university fees, increasing the coalition's credibility in terms of dealing with our huge fiscal difficulties.
• Rates need to rise anyway - If the UK economy is to return to anything looking like normality, then interest rates will have to rise, including bond yields.  Therefore, the recent increase reflects better growth prospects and a move towards stability. As such, we should welcome this modest upward shift in yields.

Overall, these are plausible arguments.  Nevertheless, the monetary policy committee seem to be behind the curve.  Their unwillingness to raise rates has increased perceptions that the inflation rate in the UK may start to pick up.  Recent inflation data underlines this threat. The Bank of England's survey on inflation expectations, released earlier this week, confirms that people are expecting higher inflation in the future.

If inflation were to pick up further, then yields would begin to pick up extremely rapidly.  Financing new government debt will become more expensive. If yields increase dramatically, then the government's fiscal reduction strategy may be in jeopardy.  There would also be negative effects on private consumption and investment.

An early hike in the bank rate would go a long way to reducing these concerns.  It would send a signal that the MPC will tackle any inflationary pressures.  It would also signal that the UK economy has started to take the first tentative steps towards the exit in terms of the financial crisis.

Unfortunately, the MPC have one eye on the large rollover problems that UK banks have to face next year and 2012.  You see, it is always about the banks.  The UK economy would benefit from a rate hike, but that banks would be squeezed. 

In any choice between the interests of financiers and and the rest of us, the financiers always seem to win.