Go back and read, if you haven’t already, this week’s Moody’s report on the UK’s AAA rating.
Then come back and read the below, from Citi.
In a Thursday note, the bank’s head of interest rate strategy, Mark Schofield, says that while “the uninformed view” is that the pre-Budget report presented on Wednesday by UK chancellor Alistair Darling left the country no nearer to, or further from, a ratings downgrade, his own view is very different. What’s more, he thinks that Moody’s report — which some might say was bearish enough, labeling the UK economy just `resilient’ as opposed to a `resistant’ to the financial crisis — is rather wrong.
For a start, Schofield thinks that Moody’s is being too generous when it says that the UK’s debt affordability (which is basically the share of revenues that must be channelled to repay interest on government debt) is set to diminish in the short-term but (importantly) likely to reverse.
Here’s his commentary:
Crucial to the UK maintaining its status are assumptions that the economy has begun to expand sustainably. Absent this assumption, the expected fall in longterm revenues has not been offset, as yet, by any commensurate reduction in expenditure and as such the European Commission sees the structural public deficit in excess of 10% of GDP. This, Moody’s describes as “an inexorable deterioration of debt affordability in the short-term under almost all foreseeable scenarios”.
Given the importance that Moody’s attaches to debt affordability, the key phrase appears to be “in the short-term”. Moody’s seems to be giving the UK the benefit of the doubt on the back of a perception that debt affordability and reversibility are high and more than likely because it feels that the outcome of the general election is too close to call and therefore the fiscal path down which the UK will go in 2010 is as yet unclear.
Looking at the Moody’s report in a little more detail, it cites among other factors, the ability to issue inflation-linked Gilts at close to zero real yields and strong demand for Gilts, albeit boosted by the asset purchase facility, as key factors that make the UK resilient rather than vulnerable at the current point in time. The other key factor supporting the UK’s rating is a belief that the public consensus will now permit any of the main political parties to follow through their pre-election pledges for fiscal restraint, whatever the outcome of the election.
It is on these points that we think Moody’s current assessment is too generous, or at least that the consensus perception of what Moody’s is saying is too complacent. We think debt affordability and reversibility look set to deteriorate rapidly and in very short order for three reasons. Indeed, it may be the case that Moody’s sees this too but that in the near term is prepared to offer a little slack while the political situation is resolved and to allow the incoming administration a short while to put a credible fiscal plan on the table. We doubt, however, that this patience will hold for very long given the rapidly deteriorating outlook and the lack of evidence of a credible solution.
The first issue, then, is the sustainability of Britain’s cheap financing — things like its ability to issue those cheap inflation-linked gilts.
As suggested above, Schofield thinks that might be a future problem:
- The first issue we have is the sustainability of cheap financing. Inflation-linked issuance will probably come in at just under 14% of total issuance this year, and while that share is likely rise in the 2010-11 remit, it is still a small percentage of overall issuance. Moreover, although inflation pressures remain very much on the radar screen, it seems unlikely that we will see such an aggressive widening of breakevens as we have witnessed this year, and thus rises in nominal yields should also see real yields move higher.
The second issue is that the things which have previously been helping maintain demand for gilts — i.e. quantitative easing — might soon disappear:
- … the demand dynamics that have hitherto supported the argument that a sharp rise in the level of the UK’s indebtedness is easily financeable are mostly transitory. Quantitative easing will probably come to an end in Q1 2010 and with it a huge portion of the existing Gilt demand will likely evaporate.
With net issuance next year likely to be running at about £16 billion per month the full force of the recent rise in issuance is likely to be felt by Gilts. Until now, quantitative easing has been offsetting just about all of the current net issuance. We expect this to put significant upwards pressure on yields in 2010, over and above the impact of higher global bond yields if the economic recovery persists.
Our model for the impact of fiscal variables on bond yields suggests to us that the current fiscal premium in the Gilt market should be getting close to 100bp. Moreover, our recent studies of the impact of fiscal variables suggest that the sensitivity of yields to changes in fiscal variables is not constant. Our analysis suggests that the sensitivity of yields to fiscal variables increases proportionately to any deterioration in credit quality. Thus Aaa issuers such as the US and UK display a sensitivity of about 7-8bp in the 10yr yield for a 1% of GDP change in the budget balance. Aa issuers, meanwhile tend to display a sensitivity in the region of 10-12bp, while single A issuers seem to have a beta of about 15-16bp for a similar change in the fiscal variables.
The issue then is that the UK ratings story could end up becoming something of a self-fulfilling prophecy; If the market thinks a downgrade is coming, it will demand a higher risk premium (something like 150bp instead of 90bp, according to Schofield), thus increasing the UK’s debt costs, diminishing the `debt affordability’ on which Moody’s places so much emphasis, and leading to a downgrade.Schofield’s third concern is that assumption in the Moody’s analysis that a `public consensus’ is enough to ensure that the UK takes up fiscal restraint.
As he puts it:That assumes that there is enough political stability to follow through with the measures. We agree that a majority Conservative government would likely initiate a sizeable fiscal tightening quite quickly. However, a hung parliament is becoming a very real threat; indeed three of the past five opinion polls suggest it is becoming a high probability risk. The issue is not so much one of disagreement over the need to enforce fiscal restraint but the fact that the parties are so diametrically opposed in their stance on how such policy should be executed. Under a hung parliament we see little prospect of a credible fiscal retrenchment and that, against a backdrop of rising yields and an exit from quantitative easing could very quickly change the ratings agencies assessments of the UK’s creditworthiness. By now you’ve probably got a good idea of what Schofield’s conclusion will be.
So, without further ado, here it is:
We understand Moody’s assessment of the short-term outlook, but we see significant risk of a marked and rapid deterioration in both debt affordability and reversibility that could quickly become self reinforcing. Unless we get a credible set of measures put in place quickly, which seems unlikely unless we get a Conservative government with a clear majority at the next election, we think the UK’s Aaa rating will be right up on the radar screens in a very short space of time. The lasting legacy of the current administration may well prove to be the loss of the UK’s AAA credit rating.
In which case, we’d like to suggest Alist-AA-ir Darling and Gordon B-ruin as some new government nicknames.
Related links:
‘Alistair in Wonderland’ believes in Santa Claus, BNP Paribas says – FT Alphaville
UK PBR – recipe for a downgrade? – FT Alphaville
RBC visualises a UK sovereign downgrade – FT Alphaville
Sovereign CDS liquidity snaps – FT Alphaville