Markets

Marcus Ashworth is a Bloomberg Gadfly columnist covering European markets. He spent three decades in the banking industry, most recently as chief markets strategist at Haitong Securities in London.

If this is safety, then I'd hate to see risk.

The surprise result of a hung parliament from Thursday’s U.K. general election pushed 10-year gilt yields back below 1 percent. As I have argued before, with inflation at 2.7 percent and climbing, real yields of around minus 1.7 percent offer little value. This would only get worse if foreign investors were to lose faith in sterling.

Gilt Trap
Greater fiscal spending would leave extremely low gilt yields exposed to a reality check
Source: Bloomberg

But the path of least resistance around Downing Street, during what looks like becoming a protracted bout of political uncertainty, is for easier fiscal policy -- and that means greater government spending.

The Conservatives had already pushed out the date for balancing the budget to after (what was then) the current parliament, so the direction of travel was established before the Labour groundswell spoke.

The political pressure is now clearly on for an expansionist budget -- the public mood for austerity has decidedly blackened, along with the desire to cut taxes for the wealthy or for corporations. Boosting fiscal spending may be all the rage, but it has to be funded somehow. Gilts remain deaf to this clarion call.

The economy's weak underlying tone adds to the pressure. First-quarter growth of 0.2 percent is underwhelming, and the prospects for an acceleration from here are dim. Furthermore, wage inflation is headed the wrong way. A weak retail sales report on Thursday should underline this grim picture.

Not Quite Strong and Stable
U.K. economic growth is losing momentum
Source: U.K. Office for National Statistics

It is a leap of faith to expect Chancellor of the Exchequer Philip Hammond to hold to his pre-election plans for relatively restrained fiscal policy, as much of the conservative manifesto is set to be junked. The prospect his next budget statement will include increased gilt issuance to plug the gap created by raised spending is a real one.

There's a Reason Why Labour Got All Those Votes
Faster inflation is squeezing consumers' spending power
Source: U.K.Office for National Statistics

He delivers his annual Mansion House speech to Britain's top bankers and business representatives on Thursday, along with Bank of England Governor Mark Carney, and he may lay the groundwork for a joint strategy to keep the economy on track. But Threadneedle Street can do little to help him. Though it's certainly possible for the bank rate to move lower, or even negative, a further reduction from the current 0.25 percent would offer just a scant amount of stimulus.

And quantitative easing may well have hit a populist wall. A further round of bond purchases by the Bank of England would smack of raising asset prices for the rich and helping out the banks.

Time for the gilt market to wake up and smell the cordite.

The Bank of England monetary policy committee meeting on Thursday will most likely produce a 7-1 decision for unchanged policy. The lone dissenter, Kristin Forbes, will be casting her last vote. Once she leaves the panel, the MPC is going to be in even less of a rush to raise rates, and certainly not at any time in the foreseeable future. Policy makers' willingness to look through any inflation spike means lower bond returns are all but baked in.

Bigger deficits and higher inflation, while the Bank of England stay on hold. Not much of an appetizing feast for potential gilt investors.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Marcus Ashworth in London at mashworth4@bloomberg.net

To contact the editor responsible for this story:
Jennifer Ryan at jryan13@bloomberg.net