Moody’s blues already anticipated by markets

The loss of the UK’s AAA has shocked nobody

WHEN Moody’s stripped the UK of its AAA rating on Friday, few were surprised. It is a move that the markets had been anticipating for months, and the lack of any significant market reaction shows just how much the decision had already been priced in. From a low of 1.4 per cent in June 2012, UK 10 year gilts climbed steadily, reaching a height of 2.2 per cent a week before the downgrade, as the markets made it more expensive for the Treasury to borrow money. When the loss of the UK’s top-tier rating was announced, yields rose to around the 2.15 per cent mark, but dropped to close play at 2.1 per cent.

UNSOUND POUND
In the currency markets we have seen a similar story. Sterling started the year at $1.62, but has steadily declined to $1.51, with the pound little affected by the confirmation of the Moody’s downgrade. This weakening pound could be bad news for Britain’s consumers – importing inflation as foreign goods become more expensive. There is, however, a contrarian view of sterling’s demise – that this selling off is vindication of the pound’s status as a haven currency. Now that the volatility of the European crisis is flattening off, there has been a move out of sterling, as investors switch into more risk-on currencies.

So what could this downgrade mean for gilts in the future? In all likelihood, very little in itself. Moody’s and the other ratings agencies have hardly shone themselves in glory over the last decade and the downgrade is going to do little to raise Britain’s costs of borrowing. With some notable exceptions, price is the best rating that there is – particularly the credit default swap market, which measures the cost of insuring debt from default. And this price downgraded Britain long before Moody’s made its announcement.

You have to also factor in the Bank of England’s quantitative easing (QE) programme. So far, it has bought £375bn worth of gilts – meaning the Bank now holds a position of around one third of the size of the entire UK gilts market. Acting as the market’s single largest counterparty, the Bank has suppressed yields and any increases in the QE programme will continue this.

There will be very few direct economic and fiscal repercussions from the downgrade. The effects are almost entirely political. Chancellor George Osborne hung his credibility on maintaining the AAA rating and has been hoist by his own petard. But should he stray from a message of cuts and austerity, watch for the bond markets to react very negatively and very quickly with significant increases in gilt yields.