Turning off the music

February 2010

The recession has certainly been bad news for workers, with insolvencies and unemployment rising to record levels. For others it has been surprisingly mild. But if the real pain from the financial crisis has been staved off by running a huge budget deficit and printing money, signals from the gilt market suggest that the day of reckoning is fast approaching.

The gilt market has been at the heart of this story for the past year. The Bank of England’s quantitative easing (QE) program kept down gilt yields so that the government could carry on spending while tax receipts dwindled. The program added £195bn to the gilt market, more than offsetting the government’s £178bn budget deficit, so the Government was able to borrow cheaply.

However, running a budget deficit of around 12% of GDP can only go on for so long before investors demand increasing returns to accompany the rising level of risk.

Two of the largest bond investors, Pimco and BlackRock, announced at the start of the year that they would reduce their holdings of UK and US government bonds citing fears that future issuance and the ending of QE, especially in the UK, will start to weigh negatively on bond prices.

In the last issue of Pensions Insight [‘The high price of Darling’s debt’] we were concerned that a hike in the ten year gilt yield in the wake of the pre-Budget Report, to 3.85%, would be the first of many. Following a spike on 19 January, that yield now stands at 4.04%.

Bond investors are right to be worried about the end of QE as there is now clear evidence that it is triggering inflation. The consumer price index (CPI) increased by 1%, a record amount, in December to 2.9% (the City estimate was 2.6%). The VAT increase has been blamed for this figure, dismissed as an anomaly by Gordon Brown. But if CPI hits 3% the Bank of England governor will be compelled to write an explanatory letter to the chancellor of the exchequer, explaining why inflation is 1% above target.

In a speech on 20 January, Bank of England governor Mervyn King said that interest rates will have to rise to combat inflation. He believes inflation will peak at well over 3% in the first half of 2010. Inflation is currently increasing across almost all categories of goods and bubbles may be emerging in some asset classes (see page 26). Even house prices are once again on the rise.

King’s unexpectedly pessimistic comments mean that the buying phase of QE is almost certainly over. If so, an increasingly hostile market must cause the value of bonds to fall.

Gilt prices would take a further hit if ratings agencies remain unconvinced that the government has a credible plan to cut the budget deficit. A downgrade would make yields shoot up. Fitch has already warned that the deficit reduction plan is too slow and Standard and Poor’s has put the UK on ‘negative watch’. King described QE as just a “massive sticking plaster on the wounds”, not a panacea.

The Bank has already lost £3.6bn as a result of yields rising during its quantitative easing program. It did so deliberately – the whole point was to depress yields by buying at over-the-odds prices. But pension funds that have also lost out are unlikely to be impressed. They will surely demand greater returns on gilts in the future and the days of cheap borrowing for all will soon be over.