QE Hopes Push UK Debt Costs Below the US
The US may enjoy the privilege of printing the world’s reserve currency, but the UK currently enjoys lower government borrowing costs – and by the widest margin in almost six years.
The US has usually been able to borrow more cheaply than the UK, and particularly so since the financial crisis, which spurred investors to dump risky assets and pile into those perceived to be the safest in the world: US Treasuries.
The benchmark 10-year bond yields of both countries have climbed from their record lows in recent weeks, but the move has been more subdued in the UK.
This pushed the difference between London and Washington’s 10-year borrowing costs to as much as 15.6 basis points in the UK’s favour on Tuesday, the widest since October 2006, although trading volumes have been light on both sides of the Atlantic.
The disparate economic outlook for the two Anglo-Saxon countries and the implications for central bank action such as quantitative easing, or government bond purchases, have been the main drivers.
A recent uptick in US economic data, particularly in the housing and labour markets, has compelled some investors to pare expectations that the US Federal Reserve will unveil a third round of quantitative easing , or QE3, next month.
In contrast, the UK’s economic output has contracted for three quarters in a row, spurring the Bank of England to announce earlier this summer another £50bn of quantitative easing through to November.
“Of all the poor growth stories, the US is still one of the best,” says Neil Williams, chief economist at Hermes Fund Managers in London. “Given the better growth outlook, the expectations for more US quantitative easing have rightly abated, while the Bank of England is still firing the QE gun.”
The UK’s 10-year gilt yields have dipped below those of comparable US Treasuries only four times since the financial crisis, most recently in April this year, when the spread spiked to 12bp in the UK’s favour.
Whether this latest move proves to be less transitory is largely dependent on the outlook for further QE by the Federal Reserve and the Bank of England.
Although expectations have dimmed recently, the likelihood of the Fed unveiling QE3 next month is not fully discounted by some economists.
The US unemployment rate remains stubbornly above 8 per cent and the economy is growing below its long-term trend rate of 3 to 3.5 per cent. For that reason, prospects for QE3 continue to animate markets.
“Market participants continue to speculate as to whether more stimulus is in the pipeline at the Federal Reserve,” says Jason Pride, portfolio manager at Glenmede.
Investors and economists are now eyeing the annual central banker meeting at Jackson Hole at the end of August for clues.
“There is a good deal of speculation that chairman [Ben] Bernanke will use his keynote address at the annual conclave of central bankers in Jackson Hole to make the case for the Fed increasing the size of its portfolio and possibly the central bank’s exposure to the mortgage market,” says Steven Ricchiuto, economist at Mizuho Securities.
In the event of QE3, the extent of a renewed sell-off in yields could be tied to the performance of stocks and commodities, which performed strongly during previous bouts of quantitative easing.
“If we get QE3 and stocks rally dramatically, then Treasury yields will back up,” predicts Michael Cloherty, a strategist at RBC Capital Markets.
Such a reaction, however, may be tempered by the fact that corporate bonds and equities have rallied sharply in recent months, ahead of a possible move by the Fed.
“It’s a lot harder for risk assets to lift from these levels given the rally we have seen,” Mr Cloherty points out.
On the other hand, many economists expect the Bank of England to be forced to extend its QE programme further in November, to avoid monetary policy from in effect tightening.
Mr Williams of Hermes says another £30bn – which would bring the total since 2009 to £405bn – could be needed in November.
If the UK economy slumps into a protracted recession, a further £450bn of bond purchases may be required, he estimates.
Christopher Iggo, chief investment officer for fixed income at Axa Investment Management, expects UK borrowing costs to stay lower than those of the US because of the higher likelihood of further quantitative easing by the Bank of England.
“The US economy isn’t in great shape, but it’s better than the UK’s, and the Fed seems ambivalent about more QE,” he says.
“I’m also worried about the longer-term outlook for US Treasuries. Given the lack of progress on fiscal consolidation, there should perhaps be a higher credit risk baked into the market.