US Treasuries  

How US Treasuries are influencing the UK market

How US Treasuries are influencing the UK market
 OLIVIER DOULIERY/AFP via Getty Images

Bonds started making headlines towards the end of February, driven in large part by what is happening in the US.

Because the US dollar is the world’s reserve currency, the US Treasury market (bonds issued by the US federal government) takes on the role of the world’s 'risk-free' asset.

Because the US federal government controls the US dollar printing press, it can always repay US treasuries at maturity – although in actual fact, many more dollars are created by computers at the US Federal Reserve than are ever printed or minted.

Leaving aside the knotty issues of willingness to pay (Congress continuing to raise the debt ceiling) and risk being defined in nominal terms rather than real, US bonds are 'risk-free' if held to maturity because they are free from default risk (see, there is a reason I used 'risk-free' in quotation marks).

There are more than $20tn of US treasuries outstanding according to US securities trade organisation Sifma, but the real power of the US bond market is that it influences essentially all other securities, everywhere.

This works as follows: Say you are interested in buying a tiny UK company that specialises in selling medical widgets solely to the NHS. You will forecast their future cash flows and profits and discount these back to the present to get a fair price for the company.

The rate you will discount these at is the UK government bond yield plus a risk premium to account for the difficulty of producing and selling widgets.

All else equal, the higher the UK government bond yield, the lower the discounted value of future profits and so the lower the price of our NHS widget maker.

So, UK bond yields influence the price of our small UK company, but how does the US get involved? Well, international investors have a choice as to whether to buy UK government bonds or US treasuries.

If the yield on US treasuries goes up, US bond prices will fall, making them more attractive investments.

Investors may then shift their portfolios to sell UK bonds (causing UK bonds to fall in price, which pushes up the UK bond yield) and buy US treasuries (slowing or even slightly reversing the gain in US bond yields).

It is not entirely a one-way street. UK yields can influence US yields too, but the US Treasury market is the biggest, most liquid market out there, so it definitely has the most influence. And that influence does extend to all assets, everywhere.

Last month the US Treasury market moved up sharply. The US 10-year bond yield started the year at 0.93 per cent, and then moved from 1.11 per cent at the end of the January to briefly touch 1.55 per cent towards the end of February, before falling back to 1.44 per cent at month-end.