Gilts Vote Down Cameron in Worst Start Since 1996 on Budget
Prime Minister David Cameron’s austerity policies, which helped U.K. debt beat world peers in 2011, are backfiring in the bond market with the economy on the brink of a recession and borrowing needs approaching records.
Gilts lost 1.92 percent in the first quarter, the worst start since 1996, after returning 17 percent last year, according to Bank of America Merrill Lynch indexes. Falling revenue means government bond sales in the next 12 months will be 64 percent higher than the average over the past decade.
While Cameron came to power almost two years ago saying recovery from the worst financial crisis since the Great Depression depended on eliminating the budget deficit and preserving the nation’s AAA credit rating, his Conservative Party now trails opposition Labour in opinion polls. Gross domestic product is projected to shrink for a second quarter and reducing upper-income tax rates amid the biggest government spending cuts since World War II has traders leaving gilts.
“The government policies in the U.K. have succeeded in implementing more austerity than in stimulating growth,” Ed Yardeni, president and chief investment strategist at Yardeni Research Inc., said in a telephone interview on April 11. “Bond markets do well in weak economies, but not if weak economies are weak because they are saddled with huge, unsustainable debt.”
Cameron, 45, toppled former Prime Minister Gordon Brown in a general election in May 2010, ending 13 years of Labour rule. He said then that the U.K. deficit was an “existential threat” to the economy and tackling it would be the focus of his policy.
As the Greek debt crisis deepened, gilts rallied and the market embraced Cameron’s medicine, which he said would restore growth, keep borrowing costs low and preserve the nation’s top rating. Now yields have risen as the economy struggles, with growth lagging behind Germany and the U.S.
Foreign investors sold a net 5.9 billion pounds ($9.4 billion) of gilts in the three months through February, the latest Bank of England data available show, compared with net purchases of 10 billion pounds in the same period a year earlier.
Gilts rebounded last week, pushing 10-year yields down 12 basis points to 2.04 percent in the approximately 1.2 trillion- pound market. Thirty-year bond yields fell six basis points in the period, to 3.25 percent.
U.K. government bonds have lost 0.6 percent this year, while German debt returned 1 percent and U.S. Treasuries slipped 0.1 percent, according to indexes compiled by Bloomberg and the European Federation of Financial Analysts Societies.
Yields on 10-year notes will rise to 2.55 percent by the end of the year, and to 2.75 percent by June 2013, according to the weighted average estimate of at least 10 analysts surveyed by Bloomberg. That’s still below the average 4.19 percent for the past decade.
Gilt yields across maturities rose 23 basis points, or 0.23 percentage point, on average, in the first three months as the economy sputtered, according to Bloomberg/EFFAS indexes. Treasury yields climbed 27 basis points on signs the U.S. recovery gained momentum, while those for German bunds increased three basis points.
“It can be a challenge if bond yields rise when the economy is still weak,” said Johannes Jooste, a strategist at Merrill Lynch Wealth Management, which is underweight gilts, meaning it holds fewer of the securities than recommended by the benchmark it uses to measure performance.
GDP in the U.K. shrank 0.3 percent in the fourth quarter from the previous three months, the Office for National Statistics said on March 28. It may have contracted 0.4 percent in the first three months of this year, the Paris-based Organization for Economic Cooperation and Development said on March 29.
“I was never a great fan of the austerity,” said Jim Leaviss, a money manager at M&G Investments which has about $300 billion in assets. “We are just not growing fast enough, and that’s got to be a concern for our indebtedness. At times like this, some fiscal stimulus would have actually been quite helpful for the U.K. economy.”
Gross debt equaled 80.76 percent of GDP last year, lower than the 100.05 percent for the U.S. and 82.64 percent for Germany, according to International Monetary Fund estimates. Switzerland’s debt-to-GDP was 52.44 percent, the data show.
Waning demand and rising yields may add to Cameron’s woes as his party’s popularity lags behind Labour by 5 percentage points, according to a Survation poll for the Mail on Sunday newspaper published on April 8. Thirty-five percent of voters said they would back Labour in a general election, with 30 percent supporting the Conservatives. The next election is due in 2015.
The government is seeking to retain the U.K.’s top credit rating by eliminating the bulk of the budget deficit, currently more than 8 percent of GDP, by 2017. The plan includes at least 80 billion pounds of spending cuts, which may lead to more than 700,000 public-sector job losses.
Fitch Ratings said on March 14 that Britain has limited ability to deal with shocks and changed its outlook to “negative” from “stable,” indicating a “slightly greater” than 50 percent chance that the AAA rating will be reduced within two years. Moody’s Investors Service said on Feb. 13 that the U.K. risks a downgrade if the economy deteriorates, which Bank of England Governor Mervyn King called a “perfectly reasonable” assessment.
Support for Austerity
Still, the 10-year gilt yield ended last week just 12 basis points above the record-low 1.917 percent reached on Jan. 18. It was at 2.05 percent at 2:39 p.m. London time today. Through last week, the equivalent-maturity Treasury yield fell about 58 basis points since the U.S. was downgraded one level to AA+ by Standard & Poor’s on Aug. 5 and, was at 1.98 percent today.
“U.K. gilt yields are close to an all-time record low, which demonstrates the government’s commitment to reducing the budget deficit,” Britain’s Treasury said in an e-mailed statement.
Some investors continue to back austerity. Gilts will outperform German bonds this year as the government retains the confidence of investors with its commitment to fiscal discipline, said Steven Major, the global head of fixed-income research at HSBC Holdings Plc in London.
“The U.K. government is doing the right thing,” Major said in an interview on April 12. “We’ve seen what happened in the euro region. Its credible fiscal program as well as a flexible monetary policy sets the country apart from some of its European peers.”
S&P affirmed Britain’s AAA rating and stable outlook on April 13, saying in a statement that Cameron will maintain his focus on closing the budget deficit.
Gains last year were driven by demand for a haven as the euro-region debt crisis intensified, and by bond purchases by the Bank of England.
Yields may now rise should the central bank end its so- called quantitative-easing program of buying debt amid the euro area’s debt turmoil and Chancellor of the Exchequer George Osborne’s fiscal squeeze, said Sam Hill, a gilt strategist at RBC Capital Markets in London.
Policy makers voted April 5 to complete their 325 billion pounds of quantitative easing, or QE. Hill said he sees a 67 percent chance the central bank will refrain from extending the program when it announces its next decision on May 10.
Inflation has been above the target of 2 percent since December 2009. Consumer prices rose 3.4 percent from a year earlier in February, compared with an increase of 3.6 percent in January, data on March 20 showed.
“The Bank of England is going to be faced with a very unpleasant reality that they may have to downgrade their growth forecasts and upgrade inflation forecasts,” Hill said in an interview on April 11. “They might not want to pull a trigger right away on more QE. Gilts are trading with QE premiums and those premiums will fade at one point.”
The U.K. plans to sell 167.7 billion pounds of gilts in the 12 months through March 2013, down from 179.4 billion pounds for the fiscal year ended last month. That still exceeds the average 102 billion pounds sold annually over the past 10 years. Issuance reached a record of 227.6 billion pounds in the period ended March 2010.
A decline in sales is based on a government forecast that the country will avoid a recession. The nonpartisan Office for Budget Responsibility said in March the economy will expand 0.8 percent this year, up from a November prediction of 0.7 percent.
Recent data were less optimistic. U.K. manufacturing output, which accounts for 10 percent of the economy, fell for a second month in February, dropping 1 percent from a month earlier, the Office for National Statistics said in London on April 5. The median forecast of 24 economists in a Bloomberg News survey was for an increase of 0.1 percent.
U.K. growth will be 0.4 percent this year, half the official estimate, and will stall until companies boost investment, Ernst & Young LLP’s ITEM Club, which uses the Treasury’s economic models for its forecasts, said in a report published today in London.
Consumer confidence is around the lowest level in almost three years after disposable income slid the most since 1977 in 2011, and unemployment remains at a 16-year high of 8.4 percent, according to reports last month.
Osborne, 40, used his March 21 budget address to reaffirm the deficit target. He extended a 20 percent value-added tax to include hot pasties, a popular pastry filled with seasoned meat and vegetables, and increased the tax on sales of the most expensive homes. He also removed an age-related allowance for retirees, while cutting the top income tax rate to 45 percent from 50 percent.
“The U.K. fiscal plans were all set out for very good reasons, but I would suggest they are too rigid for such a volatile and uncertain economic environment,” John Wraith, a strategist at Bank of America Merrill Lynch in London, said in an interview on April 12. “There can clearly be big risks in saying we are going to stick to our fiscal plans come hell or high water.”