Investment Clock insights

Philip Hammond should realise the low in gilt yields is here


Trevro Greetham

14 September 2016

Article first published in the FT on 14 September 2016.

‘Fiscal reset’ is overdue and should be focused on where it will raise growth potential.

The downward shift in UK government bond yields of all maturities since the EU referendum makes sense given aggressive easing by the Bank of England, but there is almost no value left in long-dated gilts. Market pricing sets a strong incentive for the government to issue in size to finance a significant fiscal stimulus. This is a temptation Philip Hammond, UK chancellor, should succumb to when he resets fiscal policy this autumn. Financial repression rather than austerity should be the focus to get debt down when deflationary forces are at work. Brexit may provide the excuse for shifting to a policy mix that should have been in place for years.

The shock vote to leave the EU caused a pause in economic activity, with business surveys plunging and then bouncing back. This tells you little. We saw similar behaviour after the attack on the World Trade Center in September 2001 and after the invasion of Iraq in 2003. The difference with Brexit is that lingering uncertainty about the UK’s future trading relationship with Europe may act as a constraint on capital investment and service sector exports for months or years to come. With inflation close to zero it is understandable that the BoE eased policy forcefully.

The market expects UK base rates to be close to zero by year end and to stay there for two or three years. This reappraisal of the trajectory of monetary policy coupled with further central bank bond purchases caused a large move downwards in short, medium and long-term interest rates. While the drop in yields is consistent with current monetary policy, it is not sustainable. Quantitative easing and pension fund buying have distorted the bond market so much that it is pricing in base rates averaging at 1 per cent or less over the next 30 years.

In the long run, base rates should be close to the nominal rate of growth in the economy which is about 4 per cent, 2 per cent real growth and 2 per cent inflation. The economy was expanding at that pace in the years before the referendum and with additional stimulus it will do so again a year or two from now despite the Brexit headwind. To believe in an equilibrium interest rate of 1 per cent, you need to believe either that the UK is heading into permanent deflation or perpetual economic contraction. We don’t.

Long-term yields are mispriced for short-term reasons. When equity markets are overvalued companies take the opportunity and issue stock, locking in a low cost of capital to fund future projects. If the UK government shares the view that gilts are expensive, they should be borrowing to spend, complementing the Bank of England’s efforts to keep yields below the rate of inflation.

Austerity is not the best way to achieve public debt sustainability. Better to stimulate nominal growth through government spending while suppressing interest rates. Such a policy of financial repression saw UK government debt as a share of gross domestic product drop from Japanese levels in the decades after the second world war, in effect by transferring wealth from savers to borrowers, including governments. It is the two-pronged approach Japan is mulling over today.

Austerity put enormous pressure on the BoE to use unconventional monetary policy to keep the economy moving, which it did by bidding up house prices and supercharging financial markets. The outcome of the EU referendum was in part a consequence of the inequality created, with the protest vote strongest in parts of society that felt left behind as the outward facing City of London powered ahead.

Now is indeed the time to reset fiscal policy. The government can issue bonds at 1 per cent and invest in an economy growing faster. With Brexit set to reduce economies of scale that the single European market offers, stimulus should be focused on areas that will improve growth potential. The government should counteract the lack of private sector investment since the financial crisis by improving transport infrastructure and power generation while fostering research and new technology.

The likelihood of stimulus makes me sanguine about the longer-term prospects for the UK economy but we are “underweight” government bonds in the multi-asset funds we manage.

A year or two from now when nominal growth returns to trend people will ask why base rates are so low. Overshooting on inflation is part of the plan, so I expect the BoE to make any number of excuses not to raise rates early but I don’t see long-term yields staying at 1 per cent while this is happening. Brexit could finally mark the low in yields.

The value of investments and the income from them is not guaranteed and may go down as well as up and investors may not get back the amount originally invested. The views expressed are the author’s own and do not constitute investment advice.