Gilts as Haven Defy Economy Underperforming Spain
Investors are turning a blind eye to the U.K.’s faltering economy, which is shrinking faster than Spain’s, as the value of the nation’s independent monetary policy outstrips its deteriorating growth prospects.
U.K. government bond yields tumbled to all-time lows this year as traders sought a haven from the euro-area’s debt crisis and the Bank of England boosted its program of asset purchases, or quantitative easing, to 375 billion pounds ($586 billion). The U.K. economy contracted 0.7 percent in the second quarter, while Spain’s shrank 0.4 percent.
While Prime Minister David Cameron has used the record-low borrowing costs to justify maintaining the harshest austerity program in British peacetime history, they have dropped despite the economy rather than because of it, according to Patrick Armstrong, who helps oversee $350 million at Armstrong Investment Managers LLP in London.
“Low gilt yields are a function of the U.K. being able to print money, meaning there is no actual default risk,” he said. “The weak economy is pushing down inflation, there is a zero interest-rate policy and the BOE is buying all the available bonds with QE. I think Cameron is trying to take credit where none should be given.”
The two-year gilt yield fell to a record 0.03 percent on Aug. 2 from last year’s high of 1.70 percent set on Feb. 9, 2011. The yield was at 0.15 percent at 9:31 a.m. London time today. The 10-year dropped to an all-time low 1.41 percent on July 23, and was at 1.58 percent today.
While U.K. borrowing costs have plunged over the past year, those in nations such as Spain and Italy have surged.
Spanish 10-year bond yields climbed to 7.75 percent on July 25, above the 7 percent level that triggered bailouts of Greece, Ireland and Portugal. Italian 10-year yields reached 6.71 percent on the same day.
“The U.K. is still seen as a safe haven,” said Alan Clarke, an economist at Scotiabank Europe Plc. “If you take money out of the U.K., where are you going to put it?”
Gilts maturing in a year or more have returned 3.7 percent this year, according to indexes compiled by Bloomberg and the European Federation of Financial Analysts. German bunds rose 3.3 percent, U.S. Treasuries gained 1.9 percent, while Spanish securities slumped 4.3 percent.
The Bank of England increased its bond-purchase program by 50 billion pounds on Feb. 9, and another 50 billion pounds on July 5. The central bank has also expanded its toolkit with a Funding for Lending Scheme to unclog bank credit and help pull the country out of recession.
Moody’s Investors Service lowered its growth forecasts for the U.K. last week and said the government will find it difficult to meet its timetable for cutting its debt levels.
“Should the U.K.’s growth potential have weakened significantly, then this would create a significant challenge to the government’s debt-reduction efforts and would place downward pressure on the country’s rating,” Moody’s said on July 31. Still, “the U.K. government’s response to negative developments late last year indicates it commitment to restoring a sustainable debt position.”
Moody’s, which has a “negative” outlook on the U.K.’s Aaa rating, lowered its 2012 estimate for the nation’s economic growth to 0.4 percent.
“A downgrade would likely be down to a lack of growth, which I don’t see impacting gilts, particularly as the Bank of England would probably need to do more QE,” said Anthony O’Brien, a fixed-income strategist at Morgan Stanley in London. “There is a possibility the ratings agencies might take action on the U.K. around the time of the Government’s spending review in October.”
Chancellor of the Exchequer George Osborne’s 2010 austerity program, which was extended for two years to 2017 in November, envisaged that the economy would be growing by 2.8 percent this year. Instead, it is 0.9 percent smaller than in the third quarter of 2010.
While a shortfall in tax revenue caused by the recession has led many economists to question whether Osborne can meet his goal of cutting the deficit to 120 billion pounds this fiscal year, his opponents in the Labour Party say his fiscal plans are too severe at a time when households and banks are weighed down by debt.
Even so, Osborne’s program have been crucial in keeping U.K. borrowing costs down, said Neil Jones, head of European hedge-fund sales at Mizuho Corporate Bank Ltd. in London.
“When you invest in bonds in the current environment, you are looking for return of capital not return on capital,” he said. “Austerity is a key differentiator and offers lower chance of default and greater chance of return of capital.”
Britain’s economy will shrink by 0.5 percent this year, causing Osborne to miss his budget-deficit target, the National Institute of Economic and Social Research said on Aug. 3.
The deterioration has been “even more pronounced” than previously forecast as private-sector retrenchment is made worse by fiscal consolidation and a “dysfunctional” financial system, the London-based research group said in a quarterly report.
A faltering economy may convince the Bank of England to increase its target for bond purchases once again, further supporting gilts. The European Central Bank has resisted calls for large-scale asset purchases due to concern over maintaining its independence and a reluctance to provide direct monetary finance to euro-area governments.
“The U.K. has its own currency and a fiscal and monetary policy strategy that compliment each other,” said Sam Hill, a gilt strategist at Royal Bank of Canada in London. “The inability of the ECB to conduct QE in anything like the form or on the scale that the BOE has been able to, has been part of the euro area’s problems, particularly in terms of investor perception about the stability of bond yields.”
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