Gilt prices fall off a cliff after Darling’s PBR

IT IS probably fair to say that chancellor Alistair Darling’s Pre-Budget Report (PBR) has failed to calm investors’ fears over the state of the country’s public finances. In spite of yet another warning that Britain’s prized triple-A credit rating on sovereign debt was at risk, Darling slackened the pace of fiscal tightening over the next few years and left £30bn of cuts post-2014 still unaccounted for.
In response, gilt yields surged to 3.80 per cent on 10-year government debt, as bond investors concluded that there had been a lack of progress in tackling the budget deficit and consequently demanded more compensation for holding the asset in their portfolios.

During trading on Thursday, the cost of borrowing 10-year UK gilts compared to German 10-year bunds widened 10 basis points to 81. Short maturity gilts held up better, but everything with maturities longer than five years saw yields increase by around 10-14 basis points on the day.
So what does this mean for spread betters? With gilt yields surging – and therefore prices falling – spread betters could look to go short on UK gilts in the anticipation that investors will remain concerned about the fiscal black hole as demand slackens and government issuance of bonds underpins supply.

How likely is this scenario to continue? Well, Chris Alexander, analyst at financial services firm Fortis, said: “We suspect that gilt yields have further to rise. The damage to the gilt market was somewhat self-inflicted with responsibility resting with the PBR’s woeful lack of fiscal credibility.”
And although Britain’s triple-A status is safe for now – ratings agency Moody’s said on Thursday it did not believe the UK would face any problems with issuing the required amount of debt – Alistair Darling’s fiscal complacency may unfortunately just be the beginning of the story. Britain is at risk of following in the footsteps of both Dubai and Greece and is walking into a gilts crisis.

Indeed, Henderson’s chief economist Simon Ward notes: “By delaying deficit-cutting until 2011-12, the chancellor is relying on the kindness of the gilt market as it takes over responsibility from the Bank of England for funding the current gargantuan shortfall. A big rise in gilt yields could yet derail his economic and fiscal strategy.”

Unless Britain brings down its budget deficit sharply, there is a serious risk that UK sovereign debt will be downgraded, making it more expensive for the government to service the debt. A debt downgrade may also deter some international investors from snapping up gilts at a time when the government needs to issue a record number.

Barclays Capital economist Simon Hayes says that the detail of the fiscal forecast offers little to persuade him that the Treasury has yet delivered the necessary fiscal consolidation.

“Indeed, the public sector debt/GDP ratio is forecast to rise over the course of the period to 76.2 per cent, just below the critical 80 per cent level that is seen as a threshold for AAA issuers,” he added.

Indeed, the Institute for Fiscal Studies (IFS) estimated at the end of last week that net debt as a percentage of GDP would remain high for a generation. And even worse, if the government does nothing to address the growing impact of an ageing population on the public finances, then net debt could be sustained at an astonishing 60 per cent of GDP. Prior to the financial crisis and the global recession, the government aimed to keep net debt at below 40 per cent of GDP.

With the outlook for the public finances still dismal, there is likely to be a lot of volatility in the gilt markets over the next six months in the wake of the both the spring Budget and the general election.

Spread betters should get to grips with this once staid market now and prepare themselves for an exciting 2010 that will see sharp moves in gilts.