US firm Pimco, the biggest bond trader in the world, plans to reduce its exposure to UK government gilts, as well as US Treasury bonds. In a year when Team Brown is depending on the bond markets to stump up £225 billion to pay for the RBS quasi-takeover and all the other emergency economic stimuli, this was like the Man From Del Monte telling the oranges market it’s a no to citrus products.
Gilt-edged securities, to give them their full name, are chunks of debt which are issued by HM Treasury as a means of borrowing money. As an alternative to bank loans, they are exactly the same as corporate bonds, except of course that they are guaranteed by the state, hence the golden, or gilt, edges.
Any City anorak will tell you to keep an eye on this market to follow the fortunes of the UK economy. Not only do gilt prices dictate the cost of government borrowing, which affects the size of the Scottish government budget; they also have an impact on things such as mortgage borrowing and business loans. The worse gilts perform, the poorer we are as a country.
They are already edging towards worrying territory. Ten-year benchmark gilts hit their lowest price in months just before Hogmanay and were threatening to hit new lows towards the end of last week. It is hard to say exactly what is at play here, since the influences include factors such as the likelihood of potential investors being lured into a strong stock market, future interest-rate expectations, and concerns about the end of quantitative easing.
But make no mistake about the backdrop: the deficit is set to hit £178bn this year, over four times the acceptable EU level in relation to GDP, and we plan to borrow £789bn over the next six years. While the politicians argue about whether growth will return quickly enough to offset the red ink, fears continue to mount about an international debt crisis. The credit ratings agencies downgraded Greece (twice) and Iceland over the Christmas break; worries swirl about the likes of Argentina, Ukraine and Venezuela; and the pessimists even fret about the prospects for the US. Like cartoon coyotes that have swallowed sticks of toxic debt dynamite, don’t be surprised to see explosions at some point soon...
The Pimco announcement, plus bearish noises from other big traders such as BlackRock, came just as the government was preparing for its first gilts auction last Wednesday morning. This £4bn auction of five-year securities was not expected to be a big pressure point, since shorter-term gilts tend to be more attractive and the price appealed to banks desperate to rebuild their balance sheets, but observers were still watching closely for signals on sentiment. It was surely no accident that stories emerged in the national press beforehand indicating that business secretary Peter Mandelson and Chancellor Alistair Darling were serious about addressing the deficit, to offset the PM’s more sanguine remarks the previous weekend.
Whether this did the trick or not, the result was certainly favourable. The auction was oversubscribed by 2.68 times, meaning that there was demand for gilts worth £10.7bn, which compared well with the 2.16 times achieved by a similar issue in early December. One leading trader who had been expecting a decent result confided that this was still better than he had foreseen.
Yet a more important test will come on Wednesday when £2.25bn in 40-year gilts, which are the same type as those that flopped in auction last March, are issued. If the same thing were to happen this month, now that national debt is the paramount fear, it could have an altogether more serious impact. The prospect of having to raise £225bn in gilts this financial year and circa £200bn the next at increasingly steep prices will do little to uplift anybody.
Then comes the general election, which will reveal the way things are really going. There will be gilt jitters if there is a hung parliament, since that is expected to be the least effective means of turning the economic screws; likewise if an outright winner’s post-election Budget is not tough enough. That might also trigger a dreaded ratings downgrade, which would probably force changes in economic policy. With the impeccably informed Pimco forecasting an 80% chance of a downgrade, the public spending cuts and/or tax rises will surely come thick and fast.
Where that will leave this country is another matter. The markets may insist on savage, immediate austerity, but don’t bet that it can be achieved without plunging the country into a second recession. Last week the Quality of Living index ranked the UK as just the 25th best place to live behind the likes of Hungary, Lithuania and Uruguay. If this depressed you, next year’s rankings might finish you off altogether.
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