Here’s a bit more on why the UK government’s massive spending review has had, and will likely have, less than a massive influence on the market for its bonds.
In fact — the government is detailing its cuts amid gilt yields that have rarely been lower in post-war history.
Nomura’s Jim McCormick and Irena Sekulska had a note out on Wednesday arguing that although there are plenty of good reasons to fix the British state, gilt fear isn’t in front. As they observed:
While there are many reasons that the UK may choose the road of rapid fiscal retrenchment, fear of the bond vigilantes isn’t an obvious one. Sure, there are important similarities between the UK and Europe’s periphery… The UK fiscal deficit is expected to average 11% of GDP in 2009-10 and set to remain near 10% of GDP in 2011 according to HM Treasury’s latest projections. In the previous 40-odd years, the UK deficit never topped 8% of GDP… Prior to the crisis, the UK’s government debt-to-GDP ratio was amongst the lowest in the G10 – at 45%. By the end of next year that figure is expected to be 87% of GDP according to the European Commission.
However, the structure of the markets for UK gilts and, say, Irish bonds (which are hugely foreign-held) are very different, in addition to the other macro factors favouring a gilt rally which we noted before. As Nomura continues (click charts below to enlarge):
The mix of a floating and still weak sterling, a high proportion of gilts in the hands of domestic investors, solid demand from central banks and growing demand from UK banks forced to meet Basel III thresholds provides a solid bulwark against the bond market storms.
Indeed. There are loads of institutional factors here — pension funds in the UK are keen to add more gilts in light of new rules guiding solvency ratios, as well as the trend towards matching assets to liabilities, for example.
Then again — we don’t know (can’t know) the counterfactual of what gilts would have done without the coalition having trailed fiscal cuts from taking office in May.
Still, this is also an interesting point from Nomura:
One can argue – though few have – that the UK’s current situation has at least as much in common with that of Japan’s in the mid-to-late 1990s as it does with Europe’s periphery today. In the mid 1990s Japan began its mix of super-loose monetary policy and highly expansive fiscal policy. And like the UK today, many predicted the mix would be a recipe for disaster for Japan’s government bond market.
Of course, the UK isn’t rammed stuck in a deflationary quagmire, nor are gilts quite as popular with domestic investors as JGBs are over in Japan.
But the Japanese experience is worth bearing in mind — last word goes to McCormick and Sekulska:
If the UK achieves solid growth with only modest inflation in the face of huge government spending cuts, the Chancellor is likely to get a healthy mix of strong gilts, a sustained AAA rating and a higher pound. If, by contrast, the fiscal cuts lead to sharply lower growth, perhaps even renewed recession, the gilt market is still likely to hold up reasonably well. For everything else, including the pound and the UK’s sovereign rating, it is not quite so clear… The one time Japan did attempt a major fiscal cut in the face of a weak domestic economy – its April 1997 hike of the VAT tax – Japan quickly slumped back into recession. Unsurprisingly, JGB yields spiralled sharply lower – but it was hardly seen as a triumph over the bond vigilantes.
Related links:
Handy IMF sovereign hexagon of doom – FT Alphaville
Gilt-ridden – FT Alphaville
US and UK seek different paths from disaster – FT