Britain tests ‘the kindness of strangers’ as gilts lose their lustre
Tim Wallace
7 min read
Hunt Kwarteng
It was a dire warning. Chancellor Kwasi Kwarteng was told in no uncertain terms last September that his financial war chest was evaporating.
The Office for Budget Responsibility’s decision last week to publish previously blocked forecasts showed the headroom to cut taxes or raise spending was down from £29bn in March 2022 to just £8.8bn by that autumn.
Kwarteng pressed ahead with his £45bn tax-cutting plan. Markets took fright and Kwarteng and his prime minister Liz Truss were relegated to the backbenches. The moron premium of the Truss era became a self-styled dull dividend as Jeremy Hunt and Rishi Sunak entered Downing Street.
The British Government has to pay an interest rate of 4.3pc to borrow for 10 years. This is above the 3.94pc markets currently charge the US or the 2.5pc paid by Berlin.
It’s not a position the current Chancellor wants to be in. Until the turmoil last autumn, the UK tended to pay a lower rate than the US. And pre-Covid, the gap between British and German rates was barely half the current spread. Buying British still has a premium.
According to ratings agency Fitch, the Government will spend £110bn on debt interest this year, equivalent to around one pound in every 10 that the Exchequer raises, the highest ratio of any rich nation.
With tectonic shifts expected in the bond market this year as even the Japanese start thinking about higher borrowing costs, the implications for taxes, spending and the upcoming election are huge.
“The politics, the inflation, the cost of living, the wages and the Bank of England response has all been a bit more heightened in the UK than in other areas,” he says.
Overcoming this is not a simple matter.
Higher inflation means investors demand a higher return on bonds to guard against the value of their cash being eroded by rising prices.
The Bank of England must also shoulder the blame for failing to convincingly get on top of price rises.
Orla Garvey, portfolio manager at Federated Hermes, says a disciplined response is needed to give investors more confidence in the UK.
She says: “The market is very keenly aware of the debt burden and of higher inflation, so it is really important the Government is credible in its fiscal response and the Bank of England is credible in its monetary response.”
There are hints it is working. Last month’s surprisingly large fall in inflation – to 7.9pc, still four-times the Bank’s 2pc target – was welcomed by markets.
But there is further to go to get rid of that premium.
By the end of 2021, it had snapped up £875bn of government debt under its quantitative easing (QE) programme. At times of very heavy borrowing, such as the early months of the pandemic, the Bank effectively took the strain and markets absorbed very little net new debt.
But the Old Lady of Threadneedle Street has now started selling that debt back to the market. It is currently on track to ditch £80bn of its QE stockpile this year, roughly half as bonds mature and half as it actively sells gilts.
Sir Dave Ramsden, a deputy governor, insists the process is going so well that it may be time for “a carefully considered increase in the pace of reduction in the stock of gilts in the 12 months ahead”.
Meanwhile, the Government is expected to borrow a near record £130bn this year and another £100bn next year. Traditionally, pension funds, insurance companies and overseas investors would be first in line to snap up gilts.
This opens up wider and more diverse sources of funding. But it also leaves the UK more vulnerable to violent movements in borrowing costs. Investors are prone to pulling money out of foreign countries in times of crisis.
Japan’s decision last week to rip up a cornerstone of its interest rate policy also has the potential to shock markets. Easing controls on bond buying may see investors “withdrawing abruptly” from other bond markets, the European Central Bank warned in May, with a “material effect on prices”. Japanese investors are some of the biggest investors in UK bonds.
James Athey, investment director at Abrdn, notes that “relying on the kindness of strangers” at a time of economic and political turbulence can be risky. He says: “The UK has made its problem worse for itself because of the setting of monetary policy, the volatility in government policy and the interaction of the two, so a period of something more orthodox and stable and consistent would be welcome.”
Lynch, at Aegon, notes that pension funds were one of the dominant buyers of recent years, alongside the Bank of England, to the extent that they were “almost price-insensitive buyers of gilts, and it crowded out a lot of other investors”.
“What we have seen since last year is that the pension funds have not been buying as much, and obviously we had that period in September-October of last year when they were sellers,” he says, which is worrying.
But there are also signs that some investors are returning, says Jim Leaviss at M&G Investments.
“During Trussonomics, the pound collapsed. This time, the pound is actually quite strong,” he says. “If people really were averse to owning UK assets, you would see the pound lower, rather than higher.”
Monthly figures are volatile, but the latest numbers from the Bank of England point to a rise in demand from abroad in April and May.
Households are also piling cash into newly attractive fixed-term savings accounts. Alexander Batten, at Columbia Threadneedle, calls this “the most likely source of demand for gilts” as banks in turn buy gilts to match these fixed exposures.
Investment managers, including those at Aegon and Columbia Threadneedle are also all increasingly keen on gilts.
Harry Richards, at Jupiter Asset Management, says he has “very recently started to buy” in some of his funds.
“Bonds have had pretty much one of the biggest selloffs on records,” he says. “For us, government bonds are on sale and this is the time to pick them up.”
The OBR blames an ageing population for higher costs in the decades to come, focused on pensions and healthcare spending.
Its fiscal risks report warned that, on current trajectories, the national debt will rise to 300pc of GDP in 50 years’ time. Similar threats face most rich countries.
That will test the “kindness of strangers” even further, as well as the domestic savings market.
Leaviss at M&G says that ultimately “the only way we can resolve that as a nation is to increase productivity and growth rate”. Ultimately, what matters is economic growth.
