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Gilt Investors Look to Monetary Stimulus in UK

David Oakley, Financial Times
Thursday, 9 Jun 2011 | 1:07 AM ET

Only weeks ago, quantitative easing, the emergency policy of pumping money into the financial system to revive the economy, was considered firmly over. Now, amid a stream of gloomy data that has raised renewed fears of a double-dip recession in the UK, it could soon be back on the agenda.

Sharon Lorimer

Fears for Britain’s recovery and speculation that the Bank of England could resume billions of pounds in bond purchases have triggered a rally in the UK government bond market.

Some strategists believe bond yields, which move inversely to prices, could test the record lows of last summer.

John Wraith, fixed income strategist at BofA Merrill Lynch, says: “If the data keep getting worse, it won’t be long before the possibility of another round of QE becomes more widely debated...I expect shorter dated gilt yields to fall further.” An investor at one of the biggest bond funds says: “QE is the weapon of last resort. The fact we are talking about it again shows how deep-rooted the UK’s problems may be. This should put downward pressure on gilt yields.”

The renewed talk of QE among investors has helped drive benchmark 10-year gilt yields down to 3.30 percent from 3.80 percent on April 11.

The rally has also been driven by the effects of the coalition government’s fiscal austerity measures, higher oil prices and a moribund housing market.

Significantly, it was Paul Fisher, the head of markets at the Bank of England and the man who implemented QE, who, in some investors’ eyes, revived the debate on another round of asset purchases.

Over the last two weeks, in two newspaper interviews, he has refused to rule it out. He has added that QE2 had to be considered if there was a further downturn in the economy.

The first round of QE drove gilt yields to historic lows as it involved the Bank buying 200 billion pounds of gilts and a small amount of corporate bonds.

Shortly after the Bank launched the program in March 2009, 10-year gilt yields dipped below 3 percent – levels to which the bond market has rarely fallen.

Gilt yields, which have largely traded in a range of 3 percent to 4 percent over the past two years, briefly fell below 3 percent again in the summer of last year when QE2 was first mooted amid a deflationary scare.

Yields dropped to 2.83 percent for 10-year bonds on August 31 – the lowest since the 1960s, which is as far back as most banks track data.

Gilts bulls argue that yields are likely to head lower as the government’s fiscal tightening may be excessive. They fear the severity of the government’s budget cuts are such that it could prolong the UK’s economic malaise.

Gilts bears, however, are more concerned about the stickiness of inflation – as measured by the consumer prices index – which remains at 4.5 percent, more than double the Bank of England’s target.

They warn that yields could go move higher, making another round of QE, which itself could be inflationary, a risky policy to pursue.

One investor says: “Inflation is still a risk for the gilts market. We expect to see prices rise to 5 percent this year and that could put upward pressure on yields.”

Certainly, the Bank’s failure to come close to hitting its inflation target over the past year may make it difficult to justify further QE.

So far, only Adam Posen backs QE on the Bank’s nine-strong monetary policy committee, which sets interest rates each month.

In fact, a number of strategists believe QE2 is unlikely and that gilts will continue trading in the 3 percent to 4 percent range amid a slow and sluggish recovery.

However, this is by no means a foregone conclusion with the threat of a double dip recession still hanging over the gilts market.

Prolonged weak growth may, counterintuitively, push gilt yields higher due to the danger that international investors could lose confidence in the UK economy and start to worry about the country’s triple A credit rating.

Jonathan Cloke, head of government bonds at Legal & General Investment Management, says: “The gilts market may see yields go higher, but this might be because of prolonged weak growth and the deficit concerns this would raise, rather than worries about inflation.”

Indeed Moody’s, the ratings agency, fuelled those concerns on Wednesday, saying that weak growth could hamper the government’s fiscal consolidation, which in turn could raise question marks over the UK’s triple A status.

Such a scenario of persistent weak growth could make another round of QE self-defeating, prompting overseas holders to sell gilts, particularly if they felt the Bank of England was trying to inflate its way out of trouble.

It is still too early to rule in, or out, another round of QE by the Bank. And even if there were a second wave, there is no guarantee it would have the same effect as the first, especially if overseas investors, who have been one of the main props of the gilts market in the past year, headed for the exit.

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