Pump up the volume
British finance minister Philip Hammond will have to sell more government bonds as the economy slows. The Bank of England is buying. But in a world where investors tend to tune out rate-setters’ interventions over time, central bank boss Mark Carney could find himself drowned out.
Gilts have outperformed all other major bond markets in local currency terms since Britain voted to leave the European Union on June 23. The stellar run began because of expectations that a darkening economic outlook would force the BoE to ease monetary policy. It continued after Carney on Aug. 4 cut interest rates and unveiled plans to buy 60 billion pounds of government debt over six months. Ten-year UK yields have since hit record lows below 0.6 percent, down by more than half since the EU vote.
While there’s extra demand for gilts, there will also be additional supply. Budget deficits widen when growth slows, if governments do nothing to offset the impact of falling tax revenues and higher welfare outlays. The independent Office for Budget Responsibility’s rule of thumb is that if growth is 1 percent weaker than expected, borrowing will be 0.5 percent of GDP higher than planned in the first year and 0.7 percent of GDP higher after two years.
Using these assumptions, RBC Capital Markets analysts estimate that there will 20 billion pounds more borrowing than previously planned in the 2016/2017 fiscal year purely because of the slowdown in growth. Total extra issuance could rise to 40 billion pounds if planned privatisations are shelved. And the number will be larger still if there’s fiscal stimulus to help the economy.
The Bank of England is buying more than this. Gilt yields should in theory still be able to extend their fall. But if the experience of other central banks is any guide, Carney will get an ever smaller bang for his buck. European Central Bank President Mario Draghi struggled to replicate the initial fall in German 10-year bond yields that happened just after he began buying government debt in March 2015. If Carney wants to compete with Hammond, he may have to turn up the volume.