Whether markets will be able to absorb the huge government debt issuance that will be forthcoming once the Bank of England’s quantitative easing programme ends is a hot topic at the moment.
As QE has propped up the gilt market, are gilt yields doomed to skyrocket once the BoE halts its quantitative easing programme?
It is true the huge upcoming supply of government bonds will put upward pressure on yields, particularly once the support from ongoing QE buybacks has been withdrawn.
A move toward higher yields once this significant market force is removed is a genuine concern right now. However I believe the consensus is exaggerating the risks the UK gilt market faces.
One major concern is centred around the UK’s level of government debt. The IMF forecasts for 2009 the UK Government will have a relatively large annual deficit of -11.5% of GDP, which is below that of the USA (-12.5%) but almost triple Germany’s deficit (-4.2%).
However, the UK’s total outstanding gross debt stands at 68.7% of GDP for 2009, which compares favourably with the USA (84.8%) and Germany (78.7%).
The UK Government has responded in aggressive fashion to the downturn. If QE works, the action will be short term in nature and will not leave the UK with a permanent debt burden.
Alternatively, the increase in debt could be curtailed by the arrival of a more fiscally stringent government in this year’s election. The UK has very little foreign debt and has been prudent by having the longest maturity debt profile in the G7.
Outstanding debt and re-financing needs would therefore appear relatively manageable on an international basis. Not all outcomes will necessarily be unfavourable.
Another commonly-held fear is that our exchange rate could fall. The exchange rate has already collapsed by 22% on a trade weighted basis since 31 July 2007. So a lot of the necessary adjustment has already taken place.
This adjustment process is very beneficial for an open economy such as the UK, especially when many of our trading partners are locked into using the relatively strong euro. By having a flexible currency and control over domestic interest rates, the UK is arguably in as good a position as anyone to grow our way out of our debt problem.
In the longer term, the UK has the chance to adjust to the crisis through fiscal stimulus, financial reform and a falling exchange rate; which might prove to be less negative for gilts than people expect.
Richard Woolnough is manager of the M&G Corporate Bond fund and M&G Optimal Income fund
