A couple of objections:
- Isn't it the failure to distinguish between relative and absolute yields that creates a blind spot for systemic crises? This is conjectural, but I could imagine that in the build up to the subprime crises investors switching between the stock of different banks based on relative considerations. For example, Merrill Lynch looks a good bet because Lehman Brothers is overvalued. In the same way the reason the Pound hasn't tonked isn't because of good stewardship of the economy, but because of even larger fears regarding the Eurozone. Similar to being chased by a bear, it doesn't matter how fast you are, as long as you're marginally faster than your mate. But this treats fairly similar asset classes as substitutes, ignoring the fact that people can quickly discover new substitutes if conditions change. During the financial crises the least worst bank did ok, until people decided to opt out all together. Regarding government debt, we run a similar risk of focusing too narrowly on investment classes. The fact that the UK spreads are lower than German ones only fills me with confidence if I have to choose between the two. If my range of options are wider, absolute risk becomes more important )or, more importanty, have the potential to become more important, and to do so quickly)
- Chris doesn't control for the fact that government bonds are issued in domestic currencies. As dsqured points out in the comments, isn't this a major problem?
- Why is it that markets like UK gilts? Security? Why do they want security? Because of uncertainty? It strikes me that the UK Debt Management Office is a little like a fire service that is also responsible for fire safety advice. Isn't there a slight incentive problem if the government (through it's power to tax) can provide "risk free" bonds? If I was trying to sell corporate bonds I'd be a little miffed that the state is able to outcompete in terms of security - a quality in high demand on account of the mismanagement of the economy. The popularity of gilts is not a vote of confidence, any more than the captain of the Titantic could boast that passengers where using *his* lifeboats and thus showing confidence towards the White Star.
- Guido asks in the comments, "the BoE is the biggest buyer of Gilts, suppressing yields. What happens when that stops?" In other words, to what extent do yields lose their information content when being driven so much by government action?
According to the FT they were at 4.12% 1 month ago. What am I missing?
Update: Reading back through my post I realised it might be construed that I was claiming the "naive thoughts on UK gilts" were Chris'. To clarify, these are my naive thoughts - Chris is as far from naive as I can imagine!
Update II: Chris proves me right, with a considered response to Guido here