Investors warn of lasting damage to UK bonds after fiscal shock
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The Bank of England has patched up the UK’s government bond market after the chancellor’s latest fiscal plan sent gilts plunging out of control, but whatever happens after that support runs out, some big investors say they are reluctant to buy the country’s debt again.
In a highly unusual measure to safeguard financial stability, the BoE is offering to buy a maximum of £5bn of government bonds a day until October 14 to contain a sell-off sparked by Kwasi Kwarteng’s “mini” Budget on September 23. Within days, the sell-off had became increasingly violent as it kicked off a liquidity crisis at thousands of pension funds and rattled around other parts of the financial markets.
Investors agree that this support will almost certainly keep a lid on any further volatility for now. But the episode has dulled longer-term attraction of UK government debt right at the point at which the government needs investors to step up and fund its fiscal plans. The UK Debt Management Office plans to sell £134bn of gilts by the end of March, an increase of more than £60bn from before Kwarteng’s announcement.
“We’re going to be much more reluctant to put on big trades in gilts any more,” said Christian Kopf, head of fixed income at Union Investment, a €416bn fund manager. “It has become an unpredictable market with populist policies. Even if the Bank of England has [fixed the plumbing] you are still left with an inconsistent fiscal policy.” The UK will need to offer up investors higher returns to sell its debt, raising the cost of borrowing for the government, he said.
The immediate risk for the market is a cliff edge when the BoE’s emergency intervention ends later this month. Unless the government has soothed market nerves by then, or the BoE extends the programme, that is likely to spark a renewed slump in gilts, investors say.
Kwarteng’s plan to outline a medium-term fiscal plan on November 23 could come too late to prevent further chaos.
“Liz Truss is out there trying to defend an unfunded budget,” said Luke Hickmore, a fund manager at Abrdn. “Fine, but we need to see an [Office for Budget Responsibility] report and we need to see it ideally before the end of the Bank’s current QE programme in two weeks’ time, not at the end of November.”
Prime minister Liz Truss and chancellor Kwarteng on Friday met the OBR, the UK’s official forecaster, in a bid to convince markets they are serious about bringing the country’s debt under control.
Another dent to the market could come in the form of a downgrade of the UK’s credit rating. Moody’s has already warned this week that large unfunded tax cuts threaten the government’s creditworthiness.
“The question is not will there be a downgrade, it is how many notches,” said the European head of a large global bank. The UK’s credit rating currently stands at Aa3 with Moody’s and AA with rival S&P. The banker said that a fall into single-A territory could cause some foreign investors — who own roughly 30 per cent of the gilt market — to sell their gilts.
“I think a downgrade looks completely inevitable at this point, although it sometimes takes a while for the rating agencies to act,” said Mike Riddell, a portfolio manager at Allianz Global Investors.
The country issues debt in its own currency, meaning a default is extremely unlikely, but the broader point is around the credibility of UK policymaking.
“The UK has devalued its credibility,” said Quentin Fitzsimmons, a senior portfolio manager at US asset manager T Rowe Price. “I have been in the market a long time and the most important thing is transparency and institutional credibility.” Fitzsimmons said he has been running an underweight, or negative position on UK debt since the summer, but the lack of an audit by the OBR ahead of the “mini” Budget was a red flag. “An audit is what I expect as an investor,” he said.
Some investors are also concerned about apparent inconsistencies in policy. The BoE’s new bond-buying scheme specifically targets the strains that were testing pension funds, but it also resembles the so-called quantitative easing programmes it ran after the financial crisis to stimulate the economy, which it had only recently announced it would reverse. At the same time, it is already raising interest rates to douse inflation and has said the government’s new fiscal plan will demand aggressive further tightening.
“They have to do something to give the feeling that the two authorities are not acting counter to each other,” said Niall O’Sullivan, the chief investment officer of multi-asset strategies at Neuberger Berman.