The newspapers over the past week or so have been full of alleged leaks from the government about fiscal help for the poor British consumer. Ideas floated have included a suspension of stamp duty (although HBOS has pointed out that following the 1991/1992 stamp duty holiday, house prices still fell by 8.3% in that latter year, and transactions fell to their lowest level for 34 years), and a £150 winter fuel bonus for all child benefit recipients. As with the Bush US tax rebates (about $600 per person) earlier this year, the government must hope that a fiscal ease would provide a temporary stimulus to consumption and house prices – although whether propping up property values is a good idea in itself must be open to question even if, unlike in 1991/1992, it were to be successful.
Sadly, whilst I’m all in favour of a bit of Keynesian fiscal stimulus (it eventually proved to be the route out of the Great Depression with the New Deal) the UK cupboard is bare. Tax revenues will have already started to plunge – for example, the huge fall in property transactions will hit stamp duty receipts (worth £6.4 billion per year in 06/07), and lower prices will take those transactions that do take place into lower tax bands. Other hits to the Exchequer will come from lower VAT receipts as retail sales slow, and weaker capital gains tax receipts as asset prices (shares for example) have come well off their highs. Perhaps only VAT on fuel continues to outperform expectations as petrol prices have rallied, although reported significant falls in volumes may mitigate that too (some suggest demand is down 20% from a year ago).
With economic growth slowing significantly, the other side of the equation, spending, is also likely to move in the wrong direction. Jobless claims have started to increase for the first time in nearly 2 years for example. The worrying thing is that the government’s tax and spending estimates are based on growth rate forecasts that look much too high in the current environment, and that certainly don’t discount a recession – around 2% in 2008 and 2.5% in 2009. The IMF estimates that actual growth might be around 1.4% this year, and even lower at 1.1% in 2009. The implication is that the UK will struggle to keep its debt as a percentage of GDP ratio below the magic number of 40%.
Lower tax revenues (is a windfall tax on energy companies the only answer?) and higher spending mean that we will get higher government borrowing, and therefore more gilts. As recently as the period 1999 to 2002 the government was repaying the national debt (remember Prudence?), and the UK’s Net Debt to GDP ratio was at 30.2%. Net gilt issuance this fiscal year will be £63 billion – the largest ever, and Net Debt to GDP will be 38.5%. So far the gilt market has been remarkably sanguine about this (bar a big sell off on the day that it was reported that Alistair Darling might scrap the “Golden Rule” of borrowing only to invest).
But perhaps the gilt market is right to be relatively relaxed – in fact yields have fallen by over 50 bps at 10 years since June, and gilts have outperformed investment grade bonds and high yield so far this quarter. The last time we had a borrowing scare, in 1993-94 as we were coming out of recession, the gilt market had its best ever year despite the highest ever gilt issuance! In the fiscal year 1993-94 net issuance was £47.5 billion (again, a few years earlier there had been talk of repaying the national debt) and Net Debt to GDP went above 40%. Gilts rallied hard, with 10 year gilt yields falling from 8.25% to nearly 6% by the end of 1993. I worked on the gilt trading desk at the Bank of England at the time, and it felt as if we were issuing stock every day, demand was so strong.
Although gilts rallied hard over that period, the shape of the yield curve changed dramatically. In 1992 the curve had been inverted, with 30 year gilts yielding 50 bps less than 10 year gilts. As concerns about supply grew in 1993, the curve normalised sharply and became steeply upward sloping, with 30 year gilts yielding at least 50 basis points more than at 10 years. As borrowing requirements grew, perceived credit risk of HM Government also grew and a risk premium was demanded by the market to lend at long maturities (governments could default on their debts, or, more likely inflate them away which would have been damaging to holders of long dated gilts).
My colleague Matthew Russell has done some good work on the shape of the yield curve compared with the government borrowing. It shows that given the current level of borrowing, rather than the UK having an inverted yield curve (currently 30 year gilts yield 25 bps less than 10 years) we should have a mildly upward sloping one (perhaps 10 bps positive). If borrowing deteriorates to the level that we expect it to, the yield curve should have a positive slope of more than 50 bps. That’s why, despite the ongoing pension fund demand for long dated assets, we would rather take our bullish bond position in the 10 year area of the curve than at the ultra long end of the gilt market which should underperform. For our growing band of American readers, I point you in the direction of some research on the US yield curve which comes to a similarly gloomy conclusion for long dated US bonds, here.
There are some other issues arising from all of this – the most important of which is crowding out. An unrelenting supply of low risk government paper makes it more costly for the corporate sector, with lower credit ratings, to issue debt, thus reducing their profits. Perhaps the best example of crowding out can be seen in the finance pages of your Sunday papers every week. The state-owned Northern Rock is offering interest rates of 6.5% to 7%, with no risk to depositors – this must surely raise the cost of attracting retail deposits for the rest of the struggling UK banking sector. And finally, food for thought – during the long Japanese recession, the world’s second largest economy was downgraded from Aaa to A2 by Moody’s as its borrowing burden reduced its creditworthiness. Could the UK or the US lose their AAA credit ratings?