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Government bond yields have fallen to record lows this week all around the world as investors have sought refuge from the turmoil gripping the world economy in the traditional haven of sovereign debt. Investors' concerns about the recession have seen them buying large numbers of government bonds as they favour safe investments over falling shares and other assets. This is good news for governments which are borrowing huge amounts at a cheap rate to pay for stimulus packages for their ailing economies and bank bail-outs.
But analysts caution that the sheer amount of debt being issued by governments, could push longer-term interest rates sharply higher again as countries compete to sell their debt to a small group of international investors. A rise in longer-term interest rates could act as a drag on the economy as it will lead to higher fixed-rate mortgages and corporate loans.
George Buckley, economist at Deutsche Bank in London, says the government is set to almost double the size of the market for British government bonds or gilts, over the next four years alone to nearly £1tn. "With all that new supply, the question is what yield will they have to offer to encourage people to buy it? Yields will have to move up at some point," he said.
"With a third of gilts already owned abroad, what will they have to offer foreign investors who have suffered from the fall in the pound's value? And because the UK is issuing relatively more debt than other countries, yields may move up more than in other countries."
Recessions reduce inflation which makes bonds more attractive to investors as it increases the real-terms return on the fixed rate of interest they pay each year. The current prospect of deflation, or falling prices, has added to the appeal of a fixed, positive return that bonds offer.
As investors buy more bonds, their price rises, in turn pushing the effective yield down. This means falling yields are often seen as a harbinger of recession while rising yields can point to stronger growth and higher inflation.
Yields on benchmark 10-year British government bonds fell to 3.44% yesterday, the lowest since records began 30 years ago while two-year yields fell to 1.74% in anticipation of an interest rate cut today by the Bank of England to 2%.
British yields have come under sustained pressure this week from economic data on the manufacturing, construction and services sector which point to a deep and prolonged slump for the British economy.
In the United States, 10-year Treasury yields tumbled to their lowest in 50 years on Tuesday, driven lower by confirmation that the world's number one economy was in recession. Benchmark 10-year Treasury yields fell to as low as 2.65% this week and yields have also fallen in the eurozone.
Bond yields have slumped dramatically in recent months since oil and commodity prices peaked in the summer and then fell sharply, leading to worries about deflation instead of inflation.
The 10-year gilt yield, for example, has fallen from a peak of 5.2% in the summer and others have followed a similar path.
Economists at Capital Economics predict that yields have further to fall as the world heads into a deep recession and as some countries suffer a short-lived dose of deflation, or falling prices.
The question for the medium and longer term, though, is what happens to yields as governments, particularly in Britain, issue huge new quantities of debt to cover the extra borrowing they are undertaking as a result of the recession, their tax cuts and bank bailouts. In theory, increased issuance means more gilts which could push down prices and increase yields.
The usual criticism of excessive government borrowing is known as the "crowding out" effect whereby governments compete with companies or other borrowers to sell all of their debt. That means they have to offer higher rates of return. This increase in long-term interest rates, in turn squeezes the economy because it lead to higher fixed-rate mortgages and corporate loan rates.
Alistair Darling, the chancellor, said in last week's pre-budget report that he intends to raise taxes and reduce spending growth in a couple of years. He was signalling to markets that he doesn't intend the government's current largesse to last - quite the contrary. Policy will be tightened when the economic emergency is past.
It is not clear that markets are convinced, however. Investors are already fretting about the still small, but growing, risk that governments may issue so much debt that they could struggle to pay the interest on the bonds.
So-called credit default spreads - a form of insurance on bond investments - have risen to record levels this week. The markets now rate the default risk for British government debt higher than that of countries such as Portugal, Belgium, France and Germany, although lower than Iceland, Italy, Greece or Ireland.
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