May’s public borrowing figures for the UK should not have come as such a shock to commentators. Borrowing £19.9 billion in just one month is the kind of figure you would expect in current circumstances, with a government forecast of £175 billion additional borrowing for the year. Spending is rising by a massive 7.4%. Benefit and other recession related costs are rising quickly, but the government is also keen to spend more on a variety of programmes this year. Meanwhile revenues are badly affected by the recession. Corporation Tax is down by 27%, with worse to come as the lucrative financial sector companies report lower profits or heavy losses.
Each bond issue is now an event, as the government steps up the amount it sells, and as markets watch to see if there is any suggestion that the government cannot sell the necessary bonds. This week was fine, but so it should be. Quantitative easing is still in full swing, so the government continues to buy bonds from the market at the same time as selling new bonds to the market. This allows the market to absorb the new bonds readily, whilst often making a profit on switching. Yields are also higher, making the bonds a bit more attractive.
We remain pessimistic about UK government bonds – and US ones – for three main reasons. The first is Quantitative easing has to end sometime. It will be more difficult for the government to go on selling bonds in the right quantities at low interest rates once it is no longer buying in its own bonds.
The second is that even after recent bond yield rises, the yields are still not that attractive for a long term investor. Lending to government at around 4% is clearly better than at around 3%, but it is still a low long term rate of interest compared to achievable past returns on long term funds. It offers little protection against future inflation.
The third are the continuing huge deficits the US and UK governments are running. As the UK figures show, things are still deteriorating in the public finances. There is as yet no credible plan to curb these super deficits, other than hoping for a strong enough recovery to take care of the collapsing revenues and the rising costs. As unemployment is still going up and is likely to for some time, cyclical costs will still rise. The UK government has not shown any will to curb other expenditures this year, and declines a new public spending review to put detail on its stated intention to stop the growth in public spending after a General Election. £175 billion is only an estimate, and is the gap between two very large and fast changing numbers.
In the UK it is true that the banks themselves will have to buy more government paper to comply with enhanced liquidity requirements, and true that some pension funds will step up their purchases as they receive bigger payments to correct deficits. Pension funds can also look more positively at higher grade commercial bonds, where the yields are much more rewarding.
Quantitative easing is still in full swing, so money is still finding its way into riskier assets. We remain negative about government bonds, concerned at the impact correcting the large deficits will have on both US and UK growth rates, and even a bit more cautious now than at lower price levels about our preferred risk assets elsewhere.