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The UK bond market has an attractive message for the current chancellor: you can loosen the purse strings.
Yet when Philip Hammond stands up at the House of Commons despatch box next week, he is likely to reiterate his reluctance to increase public spending, despite conditions in the gilt markets suggesting there is scope to do so.
The market is “much more relaxed than Treasury may think about the outlook for the public finances”, says David Owen, chief European economist at Jefferies. “The public finances have improved and importantly, the UK has voted to leave the EU and there is more focus on the need for a targeted fiscal response to give growth more of a chance.”
Investors’ appetite for gilts has not been truly tested since last year’s EU referendum, as, contrary to initial expectations, Britain has not needed to borrow more to counter a sudden economic slowdown.
Instead, a better than expected economic performance combined with additional quantitative easing by the Bank of England carried the UK through the initial post-referendum period with little negative impact on the markets. In the first half of this financial year UK borrowing ran at £45.7bn, its lowest level since the financial crisis and £6.1bn lower than originally forecast.
Although real yields remain negative — two-year paper is trading at around 0.48 per cent, a discount to the 0.5 per cent base rate of borrowing set by the BoE — investor demand for gilts remains strong. Last week’s long-dated index-linked syndication saw record demand.
All this amounts, some investors believe, to a convincing case for loosening the Treasury’s purse strings. An increase in funding for infrastructure and productivity improvements could help to boost the British economy, which faces growing uncertainty about the final shape of Brexit.
“The economy has slowed to a degree and yields remain low so there is clearly scope for some higher infrastructure funding,” says Mike Amey, sterling portfolio manager at bond giant Pimco. “I don’t think the market would react violently to that outcome and economically there is an argument for it. Markets’ focus for UK debt issuance is on the debt-to-GDP ratio, and seeing that on a downward trajectory is the key metric.”
An increase in gilt issuance could see yields tick upwards, increasing the government’s servicing costs, but that “is not necessarily a bad thing”, says David Lloyd, head of institutional fund management at one of the UK’s largest investors, M&G. “Yields are around the lowest levels they have been since God was a boy, and any increase in yields would be met surprisingly quickly by demand from domestic investors, particularly pension funds.”
While a rise in gilt yields would push up the government’s borrowing costs, it could be offset by a boost to the pound, suggests Mike Riddell, a bond fund manager at Allianz Global Investors.
“More infrastructure spending would probably result in more growth but it would also result in more issuance. If there was a big jump [in issuance], the gilt market would probably see that as a bit of a negative but it could be supportive to other asset classes, particularly sterling.”
With UK yields well above those of core eurozone economies, foreign buying has helped support gilts: since last year’s referendum the UK has seen a net £50bn increase in foreign investor holdings of gilts.
This is not an unbridled positive: BoE governor Mark Carney warned this summer that the UK is dependent on “the kindness of strangers” to finance its deficit — and positive sentiment can evaporate quickly.
Myles Bradshaw, head of global aggregate fixed income at Europe’s largest asset manager Amundi, says that gilts are overpriced. “As a global investor who does not need to invest in gilts to meet liabilities, there is not much rationale for me to buy gilts and I think the Treasury is aware of that,” he says. “It is not obvious why capital should be attracted to the UK.”
Also a series of indicators suggest that Britain’s economic outlook is waning. On Budget day next week the OBR is likely to downgrade its productivity forecasts, a move which will increase public borrowing projections.
The persistence of negative short-term real yields indicates an expectation by traders that the BoE will have little room to further tighten monetary policy in the coming months. Additionally, Britain is entering the riskiest period of Brexit negotiations, with markets becoming increasingly focused on the contours of its future relationship with the EU.
With central banks’ quantitative easing programmes set to be scaled back next year, the general path for developed economies’ bond yields is likely to be upwards — erasing gilts’ competitive advantage for yield-focused investors.
As a result, the Treasury may be running out of time to launch a public spending boost. Mr Hammond may find that this month’s Budget is his last chance to capitalise on the bond market’s tranquil conditions.