Gilts' real worries

There’s a delightful paradox about Moody’s decision to downgrade the UK government’s credit rating. It’s that the government’s creditworthiness is pretty much the only thing that gilt investors should not worry about.

Let’s be clear. If a government can print its own money – as the UK can but Greece cannot – it need never go bust, simply because the central bank can buy as much government debt as it has to. Granted, printing money to buy gilts might be inflationary. But Moody’s statement justifying its downgrade never mentioned inflation. And anyway, if the government’s creditworthiness is impaired by weak growth – as Moody’s believes – printing money might be the policy to boost growth.

The government’s creditworthiness, then, should not trouble gilt investors - and, indeed, the downgrade hasn’t done so. But plenty else should worry them. Here are six reasons why gilts might sell off in coming months.

1. Growth picks up. Although Moody’s cited the “continuing weakness in the UK's medium-term growth outlook” as a reason for cutting its credit rating, such a prospect is actually a reason to hold gilts. This is because the same weak growth that reduces tax revenues also makes investors unwilling to hold equities and to prefer gilts instead. The danger for gilts is that the growth outlook might improve – say because the euro area eventually pulls out of recession or if businesses step up their spending. This would trigger a shift out of gilts and into growth assets such as shares.

2. Risk appetite improves. This would probably happen if the economy looks like picking up. It could also happen if either tail risk declines further or if investors’ sentiment improves. Although foreign buying of US equities – a great sentiment indicator – has picked up recently, other indicators of sentiment such as prices of Aim stocks relative to FTSE 100 ones are relatively low. There is, therefore, scope for sentiment towards shares to increase, which would probably cause a sell-off in gilts.

3. Inflation rises. The biggest reason for the rise in gilt yields since the autumn has been that inflation expectations have risen. This might continue, if the Bank of England’s remit is changed to allow it to do more to boost growth – say by shifting to a nominal GDP target – or simply if sterling continues its recent drop.

4. Investors worry seriously about the pound. If markets expect sterling to continue to fall against the euro, they’ll require higher expected returns on gilts relative to euro bonds to compensate them for the expected loss. The gap between yields on gilts and on their German equivalents will therefore rise. So far, this has happened to only a slight degree; ten year gilts yield only 0.54 percentage points more than German bonds, which is only slightly above the average differential since January 2007. You could interpret this as a sign that gilt yields could rise further, if worries about sterling intensify.

5. QE goes into reverse. Although gilt investors might worry about loose monetary policy raising inflation, there’s also the opposite concern – that eventually, the Bank of England will put quantitative easing into reverse and sell the £375bn of the gilts it has bought. The Bank’s own research suggests that the first £200bn of QE reduced yields by a percentage point, so a sell-off of that £375bn could raise yields by almost two percentage points. This would be on top of the rise in yields caused by the higher growth and inflation which prompt the Bank to tighten policy.

6. The savings glut and shortage of safe assets diminish. A big reason for the fall in real yields since 2000 has been that there’s been a massive demand for safe assets. This has been due in part to huge savings in Asia – China’s savings have reached 50 per cent of national income – being invested in western bonds. But it’s also been due to a dearth of investment opportunities in the west causing companies to save. For example, since the end of 2005, US non-financial companies have added $3.6 trillion to their financial assets – almost twice as much as they’ve invested in real estate and capital equipment. It is, though, possible that these factors will go into reverse. Dennis Yang at the Chinese University of Hong Kong expects the Chinese savings ratio to fall in coming years as the population ages and as it shifts towards a more consumption-oriented economy. And - who knows – a pick-up in the rate of innovation, or perhaps just a need to replace worn-out kit, might get companies investing again.

None of this is to say that you should sell all your gilts today. For one thing, several of these dangers won’t hit the market for some time; the savings glut, a prospect of more QE and weakish growth are likely to stay with us for a while longer at least. And gilts are worth keeping onto as a way of diversifying many (though not all) of the risks to equities, such as bad surprises to economic activity or risk appetite.

Nevertheless, the long-term risk is for gilt yields to rise. In saying this, I’m not claiming the market is in a bubble, but merely relaying what the market already believes.

Put it this way. Ten year gilts now yield 2.12 per cent whilst five year ones yield 0.87 per cent. Why, then, would anyone choose to hold the five year gilt? It can only be because they expect yields to rise, so that when the five year gilt matures, its proceeds can be reinvested at a higher yield; a five year yield of 3.4 per cent in five years’ time is necessary to equalize the returns on ten year gilts. In this sense, rising yields are priced in.

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