British government bonds came under selling pressure last week, the one in which the Chancellor delivered his Pre-Budget Report (PBR). Over the course of the week, yields on 10-year gilts rose by 0.24%, or 24 basis points (bps) . The yield differential, or spread, versus compared to yields on comparable German bonds rose by 22bps, demonstrating that this was not just a generalised fall in bond prices, which causes yields to rise. The sell-off is a negative factor for British taxpayers, increasing the cost of government borrowing and has negative knock-on effect for most other borrowers, from commercial enterprises to mortgage borrowers.
The Financial Times was in no doubt, the culprit for the sell-off was Chancellor Darling’s failure to make sufficiently savage cuts in public spending to reassure bond investors. 'Investors took fright at the perceived timidity of the government's plans to balance the books with one of the biggest sell-offs of British gilts this year.'
But that verdict is simply and demonstrably untrue. SEB has previously shown, by analysing European government bond markets, that there is a preference for lending to economies where there is a reflationary policy. This is simply because, from the perspective of the bond market, government spending to boost the economy, especially investment, improves the chances of getting your money back.
There were some very poor choices made in the PBR. Among the worst was the decision to increase spending for the war on Afghanistan by £2.5bn. At the same an increase in National Insurance Contributions will allegedly increase revenues by £1.9bn (although no account was taken of the depressing effects on activity of this tax increase). It seems that borrowing is possible to fund disastrous and increasingly unpopular foreign wars, but tax increases on the low-paid are imperative.
Yet, although there were many changes announced by Darling, the net change in the fiscal position was close to zero (Afghan spending aside). According to the PBR, there was just £415mn of fiscal tightening announced, all of which was more than accounted for by the projected take from taxing bankers’ bonuses (£550mn). In the next year, the Chancellor estimates a loosening of £1.24bn and only in later years does net fiscal tightening begin in earnest, £3.5bn and £5.1bn in 2011-2013 - see the Chancellor’s Table. 1.2.
SEB can agree with the FT that this inaction is the cause of the sell-off in gilts. But with exactly the opposite meaning. The sell-off in gilts arises not because the Chancellor is delaying cuts, but because he has stopped trying to reflate the economy.
How is it possible to be so certain of something which flies in the face of virtually all the market commentary of the last few days? Simply because the PBR was a change in government policy away from reflation (the previous policy included a VAT reduction, corporate tax holidays, brought forward capital spending, etc.). When that policy was being pursued gilts did not sell-off. A year ago British government 10-year yields were 29bps lower and the yield spread with Germany was 31bps lower.
For confirmation of this view, we can look to Ireland. The day following the PBR the Irish government enacted its own Budget. Budget cuts there of €4bn were described by the FT as “brutal” and even “masochistic” and included public sector pay, jobseeker’s allowance, even disability benefits. The British Tory Party and their supporters in the media have lauded the ‘resolute action’ of the Irish Finance Minister Lenihan. George Osborne is preparing to emulate him. But yields on Irish 10-year government are now even higher than those on British government debt at 4.87%, and now stand at 187bps over German bunds, compared to 66bps for Britain, even though the two have similar of government deficits, close to 12% of GDP.
But what of the European benchmark, surely German yields are low because of they are pursuing a policy of fiscal retrenchment, as recommended by virtually all the commentators? German debt yields remain the benchmark low in Europe, all the while the new German government continues to reflate the economy through increased government spending, which of course is financed in the first instance by increased borrowing.
This is not simply a case of investors flocking to the traditional German safe-haven bond market, although that is often a factor. Other bond markets have avoided a sell off, and maintain tight spreads to Germany, notably France and Belgium. What all three economies have in common is that they have been engaged in fiscal expansion to lift their economies.
The commentary from the Financial Times and most bond analysts can be discounted as it does not conform to reality. The actions of bond investors illuminate the real picture; inactivity is better than fiscal contraction, but reflation is better than both..
1. Financial Times, December 14, Table ‘Bonds - Benchmark Government’, p.27