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Gilt prices on course to fall as UK public debt threatens credit rating

MARKETS were rattled last Thursday when ratings agency Standard &amp; Poor&rsquo;s announced that it had downgraded its outlook on Britain&rsquo;s AAA credit rating to &ldquo;negative&rdquo; from &ldquo;stable&rdquo; for the first time since October 1993.<br /><br />Lower credit ratings result in higher borrowing costs because the borrower is considered more likely to default on its debt. If the UK&rsquo;s credit rating were to be downgraded &ndash; Standard &amp; Poors says that the UK has a one in three chance of an actual cut &ndash; then gilt investors want to be paid more for the risk of holding government bonds.<br /><br />The yield on UK 10-year gilts, which moves inversely to the price of the bond, rose by as much as 14 basis points immediately following the announcement, but eased later on Thursday after an auction of a five-year paper drew strong demand. Sterling also fell after the outlook downgrade.<br /><br />As both UK gilts and sterling are tradable through contracts for difference (CFDs), traders can take a view on the impact of the outlook downgrade. So what should you be looking for in the near future when it comes to gilts and sterling, and what should you do if Britain were to lose its triple-A status?<br /><br /><strong>UNCERTAIN OUTLOOK</strong><br />In terms of UK government bonds, the Bank of England&rsquo;s quantitative easing programme will meet some of the demand for the record amount of gilts (&pound;220bn) that the Treasury needs to issue this year to fund its borrowing. However, the uncertain outlook for UK debt means that investors will start to demand higher yields on gilts and, as yield moves inversely to price, the price of gilts will fall. Therefore you could initially look to go short on UK gilts to capitalise on the market pricing in the revised outlook.<br /><br />However, while the yield on British 10-year gilt yield rose as high as 3.72 percent in response to the S&amp;P announcement, it failed to break through the support level of 3.73 percent, and later eased back to 3.63 percent. If yields rise further and break through 3.77 per cent &ndash; a level formed in February &ndash; then this would trigger a double bottom in the price &ndash; a key technical signal for traders to sell gilts, targeting a yield of 4.53 per cent.<br /><br /><strong>BEARISH IMPACT</strong><br />As 40 per cent of the demand for UK gilts was generated via foreign accounts, the bearish sterling impact will be significant. BNP Paribas foreign exchange strategists note that moves in the pound will occur ahead of any change by the agency because &ldquo;sterling will have to price in a risk premium to take account of the possibility of an upcoming rating downgrade.&rdquo;<br /><br />They favour buying euro-sterling but hesitate to sell sterling-dollar as US dollar weakness will dominate until the autumn when they expect current green shoots to wither, at which point it will be time to short sterling against the dollar.<br />