British Bonds Best as Cameron Austerity Makes BOE Pause With U.K. Slowdown
U.K. bonds are generating the biggest gains in the government debt market as Prime Minister David Cameron’s austerity plan postpones growth in favor of fiscal health.
Of the 26 sovereign debt markets tracked by Bloomberg/EFFAS indexes, none have done better than gilts the past six weeks, after producing the biggest monthly losses in January except for South Africa. They have returned 2.9 percent since Feb. 4, including reinvested interest, beating the 1.9 percent surge in U.S. Treasuries and 0.4 percent advance in German bunds, according to Bank of America Merrill Lynch indexes.
Cameron is braving protests and rising unemployment to push through the biggest spending cuts since World War II and close a deficit that grew to 11.1 percent of gross domestic product in the fiscal year ended March 2010. The reward for taxpayers is lower borrowing costs as the price investors pay for credit- default swaps tied to U.K. debt drops. Fitch Ratings affirmed the nation’s top AAA grade on March 14.
“In the long-term, it’s what the market was asking for,” said Ihab Salib, a money manager who specializes in international debt at Pittsburgh-based Federated Investors Inc., which oversees more than $350 billion.
Chancellor of the Exchequer George Osborne will present his budget in two days, almost a year after Cameron’s Conservatives joined with the Liberal Democrats, Britain’s third-biggest political party, to form a government with the intention of reducing the nation’s debt and preserving its top credit rating. The Conservatives ended 13 years of Labour rule in the May 6 election, when former Prime Minister Gordon Brown was defeated.
Declining Debt Sales
Gilt sales in the next fiscal year will drop to 162 billion pounds ($264 billion) from the record 227.6 billion during fiscal 2009/2010, according to the median estimate of 15 of the 20 primary dealers of U.K. debt in a Bloomberg survey.
Cameron has stuck to the fiscal measures in the face of the highest unemployment since 1994, student riots protesting increased university tuition fees and a rise in the so-called misery index to a 17-year high. The gauge, devised by economist Arthur Okun, combines inflation, which is accelerating at the fastest pace in more than two years, and joblessness.
“People are realizing the realities that come behind that kind of program, and it’s not all that good,” Federated’s Salib said of Cameron’s cuts to spending.
The government plans to shrink the budget deficit to 1.9 percent of GDP by April 2015 from 10 percent this year and slash more than 300,000 public-sector jobs. Last week U.K. lawmakers voted down a Labour attempt to force the government to reverse an increase in value-added tax on road fuel.
“The strong budgetary consolidation effort and declining fiscal risks arising from the U.K. financial sector support the stable outlook on the U.K.’s AAA ratings,” Fitch analyst Maria Malas-Mroueh in London said in a March 14 statement.
Yields on the 3.75 percent gilt maturing in September 2020 fell 12 basis points last week to 3.51 percent. Germany’s 2.5 percent bunds due January 2021 rose, sending the yield down three basis points to 3.19 percent, while the yield on the 3.625 percent Treasury note of February 2021 was 13 basis points, or 0.13 percentage point, lower at 3.27 percent on March 18.
The 10-year gilt yield was two basis points higher at 3.53 percent as of 4:24 p.m. in London today.
Longer-term gains are coming with short-term pain. Austerity measures may limit U.K. growth to 1.5 percent this year, the Paris-based Organization for Economic Cooperation and Development said March 16, cutting its estimate from 1.7 percent. That compares with 3.1 percent for the U.S. and 2.6 for Germany, according to separate surveys of more than 10 economists by Bloomberg News.
The U.K.’s FTSE 100 Index of stocks lost 1.9 percent this year, compared with a 3.3 percent jump in the Standard & Poor’s 500 Index and a gain of 2.2 percent in the MSCI World Index.
The U.K. is “incredibly challenging,” Carl McPhail, chief executive officer of Weymouth, England-based budget fashion retailer New Look Group Ltd., said March 16 on a panel at a Retail Week conference in London. “Economic uncertainty is affecting everyone,” Richard Brasher, U.K. CEO of Tesco Plc, the nation’s largest retailer, said then.
Inflation accelerated to a 4 percent rate in January from a year earlier, the fastest pace since November 2008, the Office for National Statistics said Feb. 15. A report tomorrow may show the rate in February climbed to 4.2 percent, according to the median forecast of 32 economists surveyed by Bloomberg.
That’s stepping up pressure on Bank of England Governor Mervyn King to raise interest rates, threatening the gilts rally. King said earlier this month that while boosting rates too soon would be a “futile gesture,” there is still a “perfectly reasonable case for doing it now.”
Gilts handed investors a loss of 1.98 percent in January, according to indexes compiled by Bloomberg and the European Federation of Financial Analysts Societies, as investors added to bets policy makers would increase rates for the first time since July 2007. Only South African debt fared worse, losing 2.01 percent.
Ten-year gilt yields will end the year at 4.11 percent, according to a weighted average of 16 economist forecasts compiled by Bloomberg. Bunds will be at 3.54 percent, while Treasuries will climb to 3.93 percent, forecasts show.
For now, the bond and currency markets are focused on the prospects for improvement in the U.K.’s fiscal position.
“There might be one Bank of England move this year, but certainly not as many as three so the 10-year is reasonable value at 3.5 percent,” said Robin Marshall, director of fixed- income in London at Smith & Williamson Investment Management, which oversees $20 billion. Thirty-year gilt yields at 4.5 percent “look a screaming buy,” he said. The yield was 4.26 percent at the end of last week.
While the pound has depreciated 1.4 percent over the past six months, it is up 1.9 percent this year, based on Bloomberg Correlation-Weighted Indexes that measure the performance of the world’s 10 most-widely traded currencies against each other.
Credit-default swaps insuring U.K. debt for five years fell to 54.6 basis points last week from 73.5 basis points at the end of 2010, according to CMA prices. That’s about the same as for German contracts, which dropped to 43.7 from 59.3. Swaps for U.S. debt rose to 41.9 from 41.5.
The contracts typically fall as investor confidence in a borrower improves and rises as it deteriorates. A basis point on a swap protecting 10 million euros ($14 million) of debt from default for five years is equivalent to 1,000 euros a year.
‘On Their Side’
With the U.K. austerity program being implemented, “we still look to be in a position where fiscal credibility is on their side and if they produce a budget that shows they are pressing ahead then that’s good news for investors in gilts,” said Sam Hill, a fixed-income strategist at RBC Capital Markets in London.
Bond investors also appreciate the U.K.’s insulation from the euro-area debt crisis. While the government is helping fund November’s bailout of Ireland, it isn’t participating in the region’s 440 billion-euro aid program, the European Financial Stability Facility.
The European Union and International Monetary Fund had to bail out Greece and Ireland last year, and bond prices show Portugal may be next. The yield on Portugal’s benchmark 10-year bond has closed above 7 percent every day since Feb. 4. Greece needed a rescue within 17 days of its yields breaching 7 percent on April 6, while Ireland sought aid about a month after it climbed above that level in October.
‘Clear Political Will’
“There is very clear political will for the euro project to stay alive and that probably means Germany and France have to pay for it,” said Peter Geikie-Cobb, a money manager at Thames River Capital, part of London-based F&C Asset Management Plc, which oversees more than $160 billion of assets. “On a relative basis, gilts will probably outperform core Europe.”
U.K. 10-year bond yields fell below similar-maturity French debt this month for the first time since October 2009 after European Central Bank President Jean-Claude Trichet said on March 3 he may raise borrowing costs in April. The yield spread over bunds narrowed to 32 basis points on March 18, also the least since October 2009, as EU leaders said they would bolster the region’s bailout programs.
The ECB is “keeping pressure on the bond market so maybe gilts have potential to outperform,” said Werner Fey, a fund manager at Frankfurt Trust Investment GmbH in Frankfurt, which oversees about 6.5 billion euros of debt. Rising yields on the securities of peripheral euro-region nations such as Portugal and Greece may weigh on bunds relative to gilts, he said.
Gilts are extending a rally from last year, when they handed investors a 7.6 percent return, the Bank of America Merrill Lynch indexes show. That beat a 6.2 percent increase for German debt and a 5.9 percent advance for Treasuries.
Britain’s decreasing debt sales underscore the nation’s efforts to cut the deficit, while President Barack Obama and U.S. lawmakers negotiate over borrowings.
Germany plans to sell 302 billion euros of government securities this year, a 6.5 percent reduction from its post- World War II peak of 323 billion euros in 2009. Debt issuance in the U.S. climbed to $2.25 trillion last year from $2.11 trillion in 2009.
“We are further down our consolidation path than the U.S., which makes us a more attractive asset,” said Stuart Thomson, a Glasgow-based portfolio manager at Ignis Asset Management, which oversees about $121 billion. “The U.K. is the weakest of the major industrialized economies at the moment, which should make bonds attractive. We like gilts, they are a good buy.”
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