June 1 (Bloomberg) -- U.K. government debt investors are gaining confidence in Prime Minister David Cameron’s plan to tame a budget deficit that the world’s biggest bond-fund manager described as a “bed of nitroglycerine.”
Gilts returned 2.2 percent since Cameron’s Conservatives agreed to govern with the Liberal Democrats on May 11, compared with 1 percent for U.S. Treasuries and 2 percent for German bunds, according to indexes from Bank of America Corp.’s Merrill Lynch unit. Ten-year gilt yields fell to the lowest in more than seven months on May 25, a day after the government announced 6.25 billion pounds ($9.1 billion) of spending cuts for 2010.
Fidelity International, Loomis Sayles & Co. and investors overseeing more than $1 trillion say Cameron, 43, will reduce the biggest deficit among the Group of Seven nations and avoid a downgrade of the U.K’s AAA credit rating. The coalition said it designed the cuts to send a “shockwave” through state departments and promised a “comprehensive and credible” plan to tackle the 156 billion-pound shortfall.
“The market is inclined to give the new coalition government the benefit of the doubt and see what the spending cuts look like,” said David Rolley, who helps oversee $106 billion as co-head of global fixed-income in Boston at Loomis Sayles. “There is local institutional bid for long-dated government paper, and that’s pretty useful.”
Investors demanded 94 basis points in extra yield to hold U.K. 10-year bonds rather than German bunds as of 2:08 p.m. today in London, narrowing from a four-and-a-half-year high of 103 basis points, or 1.03 percentage points, on May 7.
The 10-year gilt yield fell one basis point to 3.56 percent, after reaching a low of 3.45 percent on May 25. British securities returned 4.4 percent in 2010, beating the 3.9 percent gain for Treasuries and trailing the 6.4 percent return for bunds, according to the Merrill Lynch indexes.
“The very first decision the government has made is to bring down the deficit and that’s good news,” said Axel Botte, a strategist at AXA Investment Managers in Paris who helps oversee about 500 billion euros ($615 billion). “It’s taken out some of the risk premium and after that vote of confidence, gilts are well placed compared to U.S. Treasuries and bunds.”
European nations are under pressure from investors to cut debt after Greece’s budget deficit soared to 13.6 percent of gross domestic product last year, precipitating the biggest shock to world markets since the 2008 collapse of Lehman Brothers Holdings Inc.
Europe’s leaders pieced together a rescue package of almost $1 trillion amid speculation the euro area may break up. The extra fiscal obligations that German Chancellor Angela Merkel is taking on are making bunds riskier to investors relative to gilts. German lawmakers agreed to contribute as much as 148 billion euros to indebted European states.
Germany’s auction last week of five-year notes drew the lowest demand since March 2008. Investors bid for 6.1 billion euros of 5.45 billion euros of securities sold, a bid-to-cover ratio of 1.1, the least since the sale of similar securities on March 26, 2008, according to data compiled by Bloomberg. The government originally planned to sell 7 billion euros. The Bundesbank was forced to retain 22 percent of the offer.
“Yields have to go higher,” Michael Markovic, a senior fixed-income strategist at Credit Suisse Group AG in Zurich, said May 27 in an interview with Bloomberg Television. “Our advice to clients is really to avoid this intermediate-to-longer segment of the German yield curve.”
In the U.S., President Barack Obama is banking on measures to stimulate job growth and the economy to reduce the deficit. The White House budget office projects a record $1.55 trillion gap in the year ending Sept. 30, up almost 10 percent from last year’s $1.41 trillion.
The U.K. budget gap is like a “bed of nitroglycerine,” Bill Gross, who runs the world’s biggest mutual fund at Pacific Investment Management Co., said in January. He cited the nation’s debt load and the potential for currency devaluation as risks for bondholders.
The coalition between the Conservatives and Liberal Democrats “is a step in the right direction,” Michael Amey, Pimco’s executive vice president of U.K. fixed income, said in an interview on May 20. “But that’s just the first of a number of steps that one will need to see before gaining comfort on a longer-term outlook for the gilt market.”
Schroders Is ‘Cautious’
Schroders Plc’s David Scammell said he is “cautious” on gilts because of the size of the government’s task. David Laws, the new government’s chief secretary at the Treasury until he resigned during the weekend following revelations about his parliamentary expenses, said he found a note from his predecessor, Liam Byrne, that said: “I’m afraid to tell you there’s no money left.”
“If they can’t do something that is deemed to be credible, we are in danger of higher yields and a downgrade,” said Scammell, a money manager at Schroders in London, which oversees about $223 billion of assets. “At the moment the U.K. is in the good-market camp. But it’s right on the edge.”
Cameron’s challenge is to maintain growth in a nation whose debt will rise to 77 percent of GDP this year and may approach 100 percent by 2014, according to Standard & Poor’s. The rating company affirmed its “negative” outlook on the U.K.’s AAA grade on March 29 “in the absence of a strong fiscal consolidation plan.”
Investec Turns Bullish
The U.K. prime minister promised to accelerate deficit reductions. A newly-created Office of Budget Responsibility, headed by former Treasury adviser Alan Budd, will produce new forecasts before a June 22 emergency budget.
“The situation in the U.K. is salvageable,” said John Stopford, co-head of global fixed income in London for Investec Asset Management Ltd., which oversees about $65 billion.
Stopford has an “overweight” position in the bonds after changing from “underweight.” That means his funds now hold a greater percentage of gilts than in the benchmark indexes he uses to measure performance.
Britain’s ruling parties said May 20 they are united over the need for swift action to reduce the record shortfall.
“I fully support the efforts of the chancellor of the exchequer, George Osborne, to deal with this problem urgently,” Liberal Democrat Business Secretary Vince Cable told reporters in London as the new government presented its policy program.
Osborne, a Conservative, said deficit reduction “takes precedence, and that’s very, very important.” The program commits the coalition to cutting the deficit at a faster pace than planned by the Labour government, he said.
Bank of England Governor Mervyn King said May 12 he backs the bid to start cuts this year.
For Standard Life Investments, the outlook for gilts has improved since before the election, when investors speculated a so-called hung parliament with no outright winner would lead to a minority government too weak to tackle the deficit.
“The market has given them a bit of a thumbs up,” said Richard Batty, a global investment strategist in Edinburgh who helps to oversee Standard Life’s $175 billion. “It seems the government can work more effectively on its fiscal plan than we thought it could a few months ago.”
Cameron, who called Liberal Democrat leader Nick Clegg a “joke” before the election, made deficit reduction a focus of his manifesto. Cable, who spoke for the Liberal Democrats on financial matters before the May 6 poll, said in April rising unemployment exposed the “folly of Tory plans to pull the rug from under the recovery” with early spending cuts.
Any sign of a disagreement between the two parties over the deficit strategy may send bond yields soaring, according to Ignis Asset Management.
“The market could lose patience very quickly if it is disappointed by their efforts,” said Russ Oxley, head of rates in Glasgow at Ignis, which has about $100 billion of assets. “A market crisis would precipitate a downgrade.”
Concern that the U.K.’s rating will be lowered is premature, said Ian Fishwick, a money manager who oversees about $3.5 billion at Fidelity International, the London-based affiliate of Fidelity Investments, the world’s biggest mutual-fund company.
“The U.K. does have sufficient flexibility to deal with these problems and so long as it’s evident that they are moving in the right direction, I think the rating agencies will give the U.K. time,” he said. “The key thing that this government is going to do differently from the old government is to start tackling the deficit more quickly.”
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