Gilts as a safe haven for investors
Whatever floats your boat
Long-term interest rates are mercifully low, despite Britain’s huge budget deficit
A FORMER chairman of the Federal Reserve, Paul Volcker, once compared financial markets to a sea that was prone to occasional storms. It was better, he said, to be on a big ship when the waters got choppy. But recent events have turned this logic on its head. Market squalls have tossed some of the bigger vessels in the euro-zone flotilla, including Italy and Spain. Nervous investors are jumping instead into some of Europe’s outlying bond markets, such as Sweden, Denmark—and Britain. Although an unlikely haven because of its weak economy, huge private debts, high inflation and swollen deficit, Britain’s ten-year bond yield—ie, the price the Treasury must pay to borrow money for a decade—fell to a record low of 2.2% this month.
Plunging bond yields are not grounds for great cheer. In part, they reflect a fearful retreat from riskier equities and an expectation that low interest rates as a medicine for a sick global economy will be around for a while. But the chancellor of the exchequer, George Osborne, has been quick to claim that the drop in the government’s borrowing costs indicates the markets’ confidence in his deficit-reduction plan.
There is something to this. In early 2010, even as the euro’s debt crisis was building, Britain’s bond yields were on a par with those of Spain, which has a similarly large budget deficit but smaller public debt. Their paths have since diverged (see chart below). Bond markets, it seems, have taken a more clement view of Britain than of Spain, even though GDP has risen by only 0.7% in the past year in both countries. Mr Osborne’s plan, first unveiled in June 2010, has helped distance Britain from fiscal troubles in the euro zone. It may, of course, simply be that the fetters of euro membership alarm investors more than red ink.
Yet it would be a mistake to put too much trust in that interpretation. Britain is still an outlier in terms of its budget deficit, which was a touch below 10% of GDP in the financial year ending in April. Only America, Greece and Ireland had bigger deficit ratios last year. Two of those have lost the faith of markets; America will be the first port of call for anxious investors for as long as it remains the world’s main reserve currency. Britain is adding to its public-debt burden at a faster rate than most others and bond markets can turn quickly, so it is prudent to shrink the deficit towards the rich-world norm. That said, credibility won by this year’s fiscal tightening may buy the space to cut more slowly in future, if the economy stays weak.
The job of sparking the economy to life thus falls to the Bank of England. It has kept interest rates at a low of 0.5% and might yet launch another round of “quantitative easing” (creating money to buy government bonds and other securities) if the euro crisis turns even nastier. But the bank’s loose-money stance is awkward given that inflation was 4.4% in July and has exceeded the 2% target for most of the past four years.
One interpretation of the bank’s policy is to think of it as setting interest rates that allow nominal GDP growth (ie, growth in the real economy plus inflation) at a rate that would be consistent with its inflation target, absent unexpected price shocks such as a sudden rise in the cost of oil (see Economics focus). On that basis, policy has not been unduly slack: the growth rate of nominal GDP is in line with its average rate in recent years (see chart). The bad news for Britain is that too much of this has been inflation—because of high oil prices, a weak pound and increased VAT—and too little from real growth.
A budget tightening plus loose money is the right way to insure against risks. Britain’s household debt is among the world’s highest as a share of income; most of it is charged at variable interest rates and thus linked to the borrowing costs set by the Bank of England. Even a small rise in interest rates would hurt borrowers, increase bad debts and perhaps even spur fire-sales of homes. A loss of a triple-A bond rating would be more painful for Britain than for most countries, because the state stands behind an oversized banking sector. Britain must avoid the spiral that afflicts some euro-zone countries, in which sovereign-debt fears lead to worries about bank solvency, raise banks’ funding costs, slow the economy and hurt tax revenue.
In a healthier economy, low bond yields would normally be a catalyst for investment by companies, as yields on gilts, as British government bonds are known, are a benchmark for the cost of long-term commercial borrowing. Alas, many firms are already sitting on cash they seem unwilling to spend. Thus the main benefit of low yields is to the public finances. Britain plans to issue £169 billion ($277 billion) of bonds this year to cover the deficit, and to pay off £49 billion of debt that is coming due. Lower interest costs will make cutting the deficit a little easier in future years. That is a small mercy. A bigger one is that investors still trust gilts, despite Britain’s many problems.