That was a terrible warning. Last September, Chancellor Kwasi Kwarteng was told in no uncertain terms that his military financial capital was evaporating.
Fiscal Responsibility's decision last week to release previously blocked forecasts showed that the margin for tax cuts or spending increases had dwindled. from £29bn in March 2022 to £8.8bn by autumn.
Kwarteng promoted his £45bn tax cut plan. The markets freaked out and Kwarteng and his prime minister, Liz Truss, found themselves on the bench. An idiotic Truss-era bonus turned into a self-styled boring dividend when Jeremy Hunt and Rishi Sunak took to Downing Street.
But nine months after the fiasco, the markets haven't fully bounced back yet.
The British government must pay an interest rate of 4.3 percent to take out a loan for 10 years. This is above the 3.94% currently charged to US markets, or the 2.5% Berlin pays.
2907 UK borrowing costs
This is not the position the current chancellor wants to take. Before last fall's riots, the UK generally paid a lower rate than the US. And before Covid, the gap between British and German rates was barely half the current spread. Buying British still has a premium.
This is bad news for the government. Now with a mountain of public debt equivalent to the size of the economy, higher borrowing costs are taking a toll on public finances.
According to ratings agency Fitch, the government will spend £110bn this year paying interest on the debt, the equivalent of about one pound out of every 10 raised by the Treasury, the highest of any rich country.
Given the expected tectonic shifts. in the bond market this year, as even the Japanese start thinking about higher borrowing costs, the implications for taxes, spending and upcoming elections are huge.
James Lynch, investment manager at Aegon, says the legacy of political risk combined with fears that the UK is more exposed to inflation than other countries, suggests that the UK is more vulnerable to rising borrowing costs.
“Politics, inflation, cost of living, wages and the reaction of the Bank of England are all in the UK it was slightly higher than in other regions,” he says.
2907 Soaring UK External Debt
Coping with this is not easy.
Higher inflation means investors are demanding higher bond yields to keep their cash from being devalued by rising prices.
The Bank of England should also take the blame for its failure to deal convincingly with rising prices.
Orla Garvey, portfolio manager at Federated Hermes, says disciplined action is needed to boost investor confidence in the UK. .
She says: “The market is very keenly aware of the debt burden and higher inflation, so it is very important that the government is credible in its fiscal response and the Bank of England is credible in its monetary response.”< /p>
There are hints that this works. The surprisingly large fall in inflation last month to 7.9%, still four times the Bank's target of 2%, was welcomed by the markets.
But there is still a lot of work to be done to get rid of this premium.
As the public debt has risen from 35% of GDP before the financial crisis to over 100% today, the Bank of England has become an important new buyer of securities.
2607 Interest on debt
By the end of 2021, it had taken on £875bn of public debt through its quantitative easing (QE) program. In times of very heavy borrowing, such as the early months of the pandemic, the Bank handled the load efficiently and markets absorbed very little net new debt.
But the Old Lady of Threadneedle Street has now begun to sell this debt back to the market. The company is now looking to shed its £80bn of QE holdings this year, about half as bonds are redeemed and half as securities are sold.
Sir Dave Ramsden, Deputy Governor, insists that the process is going so well that it may be time for «a carefully considered increase in the rate of gilt reduction over the next 12 months.»
Meanwhile, it is expected that that the government will borrow a nearly record £130bn this year and another £100bn next year. Traditionally, pension funds, insurance companies and foreign investors have been first in line to buy up securities.
According to the OBR, more than a quarter of government debt last year was held by foreign investors, about twice as much. share two decades ago. This puts the UK second only to France among the G7 countries.
2907 who buys UK debt
This opens up wider and more diverse sources of funding. But it also makes the UK more vulnerable to sudden changes in borrowing costs. Investors tend to withdraw money from foreign countries during a crisis.
Japan's decision last week to break the cornerstone of its interest rate policy could also shock the markets. The European Central Bank warned in May that easing controls on bond purchases could lead to a «drastic exit» of investors from other bond markets, which would «materially affect prices.» Japanese investors are among the largest investors in British bonds.
James Athey, chief investment officer at Abrdn, notes that «relying on the kindness of strangers» during times of economic and political turmoil can be risky. He says: «The UK has exacerbated its problem with monetary policy adjustments, public policy instability and their interaction, so a period of something more orthodox, stable and consistent would be welcome.» /p>
Aegon's Lynch notes that pension funds have been one of the dominant buyers in recent years, along with the Bank of England, to the extent that they have been «nearly price-insensitive buyers of pigs, and this has crowded out many other investors.» .
“Since last year, we have seen that pension funds have not been buying much, and obviously we had a 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 of M&G Investments.
“During the Trussonomics, the pound collapsed. The pound is actually pretty strong this time around,” he says. “If people really didn’t want to own British assets, you would see the pound fall, not rise.”
1207 Sterling index higher than ten years ago
Monthly figures are unstable, but the latest figures from the Bank England indicate an increase in demand from abroad in April and May.
Households are an additional source of demand for public debt. Tax breaks mean people are «buying aggressively» to get cash, says one asset manager.
Families are also investing in attractive new fixed-term savings accounts. Columbia Threadneedle's Alexander Batten calls this «the most likely source of demand for gilts» as banks in turn buy gilts to match these fixed risks.
Investment managers, including those at Aegon and Columbia Threadneedle , are also increasingly into pigs.
Harry Richards of Jupiter Asset Management says he has «very recently started buying» some of his funds.
“Bonds experienced one of the biggest sell-offs in history,” he says. «For us, government bonds are selling and now is the time to take them.»
The higher yields on offer should help protect the government for now. But the long-term risk is that the UK's debt will continue to rise.
The OBR blames an aging population for higher spending in the coming decades, mainly on pensions and health care costs.
The Fiscal Risk Report warns that under current trajectories, public debt will rise to 300% of GDP in 50 years. Most rich countries face similar threats.
This will further test the «kindness of strangers» as well as the domestic savings market.
M&G's Leaviss says that ultimately «the only way solve this problem as a nation — increase productivity and growth.» Ultimately, what matters is economic growth.
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