Rising interest rates around the world will not yet lead to another financial crash – here's why

That was the week that was – at least for financial markets.

After a vicious meltdown, US markets bounced back on Friday, though not quickly enough to rescue UK shares. The FTSE 100 index closed at 6996, having lost more than 10 per cent of its value since its peak of 7877 in May. That, in the strange euphemistic jargon of the markets, qualifies as a “correction”.

So once again we have been reminded that what happens in the US still dominates the world markets. When America sneezes, the rest of us catch a cold.

What should we make of all this? Several points.

For a start, some sort of correction has been overdue. Whenever share prices race upwards, as they have in the US, some people feel it might be time to cash in their profits. Historically October has been a dangerous month (crashes in 1929, 1987 etc) though I have never seen a satisfactory explanation of why this should be so. This time there may have been a technical explanation, with an initial fall triggering programmed selling. Tell the computers that they should sell if prices fall by x per cent and they all pile in together.

But the background to weakness this autumn is fascinating, because as far as I can see the trigger was the rise in US bond yields. The ten-year rate nudged 3.25 per cent last Monday, having been as low at 2.85 per cent at the end of August. This is really just a return to normality, after several years of exceptionally low rates, a return that the US has embarked on, with the UK and even more tardily, Europe, lagging behind.

UK gilt yields have come up from their floor two years ago and now yield 1.5 per cent. But that on a long view is ridiculously low: they were yielding more than 3 per cent as recently as the end of 2013.

Rates in Europe are even lower. The equivalent German bonds yield only 0.5 per cent. If you want higher rates in Europe you have to go to Italy, when the ten-year yield is 3.6 per cent. So the Italian government has to pay a 3 per cent premium over the German government to borrow money for ten years. Why? The word is risk: the risk, still seen as small, that the country might leave the euro and renegotiate its debts.

The big point here is that interest rates are rising worldwide. This is not just about the decisions of the central banks. The long decline in bond yields that started in the early 1980s reversed two years ago, and there is every prospect of a long period of rising rates. But the rise will not be a straight line. Far from it. There could be periods of three years or more when rates fell. Indeed you would expect that, given there is an economic cycle and rates respond to that: they tend to rise with the booms and fall with the slumps.

Several things follow from this.

One is that if rates keep rising, the price of bonds (which move in the opposite direction to bond yields) will fall and that will tend to pull down other asset prices. That is the simplest explanation for the events of last week.

Another is that anyone with large debts – an individual, a company, a government – will be squeezed. There will be sellers of distressed assets. People who cannot afford to service their mortgage at a higher rate may find they have to put their homes on the market. Companies will have to sell off divisions or assets to hold down their debts, and some will go under. And governments? Well, I think there will be more defaults.

If this is all so tough, does this mean that there will be a recession as a result, a re-run of 2008/9 but with even more dire consequences?

That depends on how fast rates rise. Mario Draghi, president of the European Central Bank, said this week that the key global risk was a sudden jump in interest rates. He is quite right. The ability of the central banks to hold rates down, however, depends on what happens to inflation. Remember that central banks control short-term rates, but they cannot directly control long-term ones. If inflation goes up sharply or people start to distrust borrowers, then anyone with spare cash will sit on it, or buy gold or something else, rather than lend money on bonds that may never be repaid.

Intuitively, there need not be the sudden jump in rates that Draghi fears. There very probably will be some sort of slowdown in a couple of years’ time, but it need not be that dire re-run of 2008/9 for three reasons.

One: the central banks and major governments will not allow a banking crash on the scale of 2008. They have seen the costs of their failure. Put bluntly, it would have been much cheaper for taxpayers, and do much less damage to the economy, to have rescued Lehman Brothers then let it go down.

Two: everyone has the recent memory of that recession and will be more cautious in advance of the next one. Actually that wobble in the market of the past few days is a healthy indication of underlying caution. When politicians claim they have abolished boom and bust that is the time to head for the hills.

Three: there is only limited inflationary pressure in the world, and by and large governments have cut their deficits to acceptable levels. That gives the policymakers more room for manoeuvre, both on monetary and fiscal policy.

Of course these rumbles of last week may deteriorate into a wider and sustained stock market retreat. But we have had those before many times. What happened is not yet a signal of a general economic retreat. Not yet.