It just had to happen. On Wednesday afternoon after the UK Chancellor’s Pre Budget Statement, the UK government bond market started to tumble. The following day, the falls became serious.
We have warned clients not to be trust in gilts for several months. We have sold all gilt holdings from discretionary portfolios. The arithmetic of the UK public finances never made any sense. The banking risk that the state is running is too great. Once quantitative easing comes to an end it is likely interest rates will rise and prices fall.
The declines set in before the ending of QE because the markets can now see for themselves there is no credible plan to reduce the UK deficit. The Pre Budget Report, far from tackling the problem, increased spending, taxes and borrowing. Markets wanted spending and borrowing to fall, and did not want to see more taxes on enterprise, saving and investing. Many market participants want the UK to attract and grow more business to earn more revenue.
The PBR documents revealed a further increase in the forecast borrowing for 2009-10 and 2010-11. The government proposed a generous increase in pensions in the circumstances, and further increases in benefits and free school meals. It is introducing another 0.5% increase in the payroll tax, National Insurance, and a one off bonus tax on financial businesses. School, hospital and police budgets will be ring fenced to avoid cuts, making the need for reductions elsewhere that much larger. The Treasury remains wedded to its idea of halving the deficit over the following four years. This Statement moved more of the reduction to the second half of that period, and failed to explain where the individual spending cuts and further tax increases would come.
The markets had wrongly hoped for something clearer and better thought out. They were prepared to accept the government idea that the cuts should not begin before recovery is underway, but they did expect a sharper definition of recovery and the cuts that would then be needed. It is anyway an arguable point that you have to avoid spending cuts before a recovery commences. In 1981 spending cuts and loose money policy powered the recovery. In the early 1990s earlier action was taken to curb a lower deficit, but this did not prevent recovery.
In the week that Greece suffered its second downgrade to BBB+ status for its bonds, and the week in which Ireland took the axe to public spending in a dramatic way, the UK package was never likely to impress many in the markets. Gilts have fallen. Interest rates for the government have risen. I fear there is more to come along the same lines, unless the government has second thoughts and does set out a credible path for the earlier reduction of the deficit.
The government’s bond salesmen were out in force saying that the ending of QE did not mean the end of low interest rates. The Bank of England is currently wishing to keep short-term rates down for longer. The commercial banks have to start buying more government bonds to meet the new liquidity requirements, just as the Bank of England throttles back on it purchases. All this was not enough to win people over. Selling another £200 billion on top of this year’s generous supply remains a tall order. Confidence is a precious flower. It is not easily cultivated, but it is easily crushed.