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UK Gilts: Resting on a Bed of Goose Down

Moorad Choudhry
Friday, 5 Aug 2011 | 12:57 AM ET

This week UK gilts featured prominently in the media when the 10-year yield dropped to its lowest levels in a long time. Is this is a vote of confidence in the UK economy? In a word, yes.

Big Ben
Don Klumpp | Iconica | Getty Images
Big Ben

Take the historical performance first. Since January 2010, the 10-year gilt yield has dropped by over 114 basis points, a good performance and an excellent return for investors. Currently, the yield is 2.74 percent, which when converted to its US dollar-equivalent is 2.67 percent, virtually identical to the current 10-year US Treasury yield of 2.60 percent. This is good news for the taxpayer as government borrowing costs are as low as they possibly could be in the present circumstances.

This is a far cry from 1976, when an IMF bailout occurred. In an environment of decreasing genuinely risk-free assets, Gilts are the latestsafe haven. And it doesn’t matter if it boils down to an ugly sisters’ beauty contest: everything is relative.

We have noted previously that investor confidence relies heavily on perception. The UK government’s “Plan A” has had the effect of communicating to the market that it is serious about tackling the budget deficit. A credible restructuring plan requires a combination of spending cuts and tax rises, and this has featured in the government’s policies. The UK’s credit default swap price has improved while the southern euro zone’s has deteriorated badly. At the same time, sterling has held up well, in January 2010 it was at 1.61 against the US dollar and is currently at 1.64. In short, investors have concluded things are positive on the outlook for the UK economy or, at the very least, conditions are better here than they are in much of the EU.

This isn’t a universal view. Some commentators have suggested that the fall in Gilt yields is not a sign of confidence, but rather a sign of weakness: it means that interest rates are not expected to rise in the future because the economy is weak. By the same logic, Greek or even Sudanese or Afghan government bonds should all be trading at 1 percent. First, bond yields, like FX rates, reflect a wide range of macroeconomic factors as well as supply and demand. But they do not trade lower when investors lose confidence in the borrower. People don’t buy bonds when they think the economy is going to underperform in the next 10 years, they sell them. Secondly, the 10-year bond yield is much less sensitive to the central bank base rate than say the 6-month or 2-year bond. The timing of the next rate tightening cycle is of little relevance to institutional investors buying long-dated bonds.

Another comment to refute is that if the UK is now a “safe haven”, one should expect that sterling would have appreciated, when (as we note above) it is more or less at the same level as last year. But this is fallacious thinking as well: US Treasuries have been a safe haven for years, during exactly the same period that the US dollar has been weakening.

Falling UK bond yields are a sign that government economic policy is on the right track. Otherwise, we would be borrowing at southern euro zone prices. We have suggested previously that the fiscal side emphasis of the current “Plan A” needs to be supplemented by supply-side measures as well, especially with respect to the labour market and youth unemployment, but we should at least acknowledge that without the current effort to tackle the public sector budget deficit, things would be a lot worse than they are now. Gilts deserve their safe haven status.

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Dr Moorad Choudhry is Head of Business Treasury, Global Banking & Markets, Royal Bank of Scotland, and Visiting Professor at London Metropolitan University.

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