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Gilt Sales May Drop as Osborne Seeks to Tame Deficit

U.K. Chancellor of the Exchequer George Osborne
U.K. Chancellor of the Exchequer George Osborne speaks at Mansion House in London. Photographer: Chris Ratcliffe/Bloomberg

U.K. gilt sales may fall 28 percent this fiscal year as Chancellor of the Exchequer George Osborne cuts spending to reduce the budget deficit and safeguard the nation’s top credit rating.

The government will issue 165 billion pounds ($246 billion) of gilts in the year ending March 31, down from 185.2 billion pounds projected in April and last year’s record 227.6 billion, a Bloomberg survey of 15 bond trading firms that deal with the debt agency shows. Osborne will present his emergency budget on June 22, the first since the Conservative-Liberal Democrat coalition came to power last month.

The Chancellor is set to outline the deepest spending cuts since the 1970s to rein in the deficit, which amounts to 11.1 percent of gross domestic product, the biggest among the Group of Seven nations. Britain faces a “formidable” fiscal challenge and needs to accelerate plans to scale back spending, Fitch Ratings said on June 8. Osborne announced an initial 6 billion pounds of reductions on May 24.

“There is no doubt this government is serious about cutting the deficit,” said John Wraith, a London-based U.K. fixed-income strategist at Bank of America Merrill Lynch, one of the Gilt Edged Market Makers, or GEMMs. “We expect gilt issuance to fall.”

All the 15 primary dealers in the survey expect Britain to retain its top AAA rating in the next 12 months. Estimates of gilt issuance range from Royal Bank of Canada’s forecast for 156.9 billion pounds to JPMorgan Chase & Co.’s estimate of 185 billion pounds.

Post-Election Outperformance

U.K. government bonds outperformed both their U.S. and German counterparts following the May 6 election that ousted former Prime Minister Gordon Brown’s Labour Party after 13 years in power. Gilts returned 1.9 percent, compared with a gain of 1 percent for Treasuries and German bonds, according to Bank of America Merrill Lynch Indexes.

Gilt issuance swelled in the previous fiscal year as the global recession prompted Brown’s government to fund stimulus programs when tax revenue slid. Britain has a bigger budget hole than the previous government forecast, the country’s fiscal watchdog said in an initial report on June 14.

Cyclically adjusted net borrowing, a figure that shows the part of the deficit not linked to the state of the economy, is forecast to fall to 2.8 percent of GDP by April 2015, from 8 percent this year, instead of the 2.5 percent predicted by the Treasury in March, the Office for Budget Responsibility said. The economy will also expand more slowly than forecast, it said.

‘Rule of Thumb’

“The issue here is when these measures will be implemented,” Bank of America’s Wraith said of Osborne’s budget plan. “There’s concern in the market, which I share, that if they get carried away too early, they could end up doing more harm than good by putting the economic recovery at risk.”

Osborne said yesterday that it remains a “good rule of thumb” that spending cuts account for 80 percent of the fiscal consolidation and that tax increases make up 20 percent.

The budget office, which provides forecasts that are independent from the government, forecast on May 14 that GDP will rise 2.6 percent next year, instead of the 3.25 percent predicted by Labour in March. Former Bank of England policy maker Alan Budd and his colleagues at the agency will release revised forecasts on June 22 to account for budget measures.

U.K. GDP may expand 1.2 percent this year, according to the median estimate of 15 economists surveyed by Bloomberg. It may grow 2.25 percent in 2011, according to the median of 14 estimates of analysts compiled by Bloomberg.

Fiscal Challenge

“It’s all about making choices,” said Sam Hill, a fixed-income strategist at Royal Bank of Canada in London. “The choice that George Osborne has taken is to err on the side of satisfying investors and gaining their confidence, and accepting that the cost of that is probably the growth rate in the near term. That should be positive for gilts.”

Fitch said on June 8 that the scale of the country’s fiscal challenge is “formidable.” Standard & Poor’s affirmed its “negative” outlook on the U.K. on March 29 “in the absence of a strong fiscal consolidation plan.” Prime Minister David Cameron has warned that the squeeze will “affect every single person in our country.”

U.K. bonds have rallied even as public finances worsened amid the perception that gilts are relatively safer than debt in the euro region as the sovereign-debt crisis has deepened.

Yields Drop

“A downgrade is unlikely given the new government appears to be tackling the problem and demonstrating commitment,” said Pavan Wadhwa, head of European interest-rate strategy at JPMorgan Chase & Co. in London. The “primary deficit is large but not dissimilar to the U.S., where there appears to be less focus on this issue. But any signs of slippage in fiscal tightening in the future could prompt a rating change.”

The yield on the 4.75 percent bond maturing in March 2020 rose 2 basis points to 3.52 percent as of 12:10 p.m. in London. Benchmark 10-year gilt rates have dropped 91 basis points since the last day of September 2008, the month Lehman Brothers Holdings Inc. collapsed.

During the same period, the yield on Germany’s 10-year bund fell 126 basis points to 2.76 percent, while the 10-year U.S. Treasury note yield slid 54 basis points to 3.28 percent.

Issuance Forecasts for fiscal 2010/2011 by Gilt-Edged Market Makers (in billions of pounds):

Median Forecast:                        165

Royal Bank of Canada                    156.9
Citigroup Inc.                          161
Royal Bank of Scotland                  161
HSBC Holdings Plc                       162.3
Nomura International Plc                164.8
BNP Paribas SA                          165
Jefferies International Ltd.            165
Toronto-Dominion Bank                   165
Credit Suisse Group AG                  167
Barclays Capital                        168.2
Morgan Stanley                          174.8
Bank of America Merrill Lynch           175
UBS AG                                  180
Deutsche Bank AG                        181
JPMorgan Chase & Co.                    185

     Goldman Sachs Group Inc. and Winterflood Securities Ltd.
didn’t participate in the survey.

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