Explosion in gov’t borrowing won’t push up gilt yields - Capital Economics
UK Economics

Explosion in gov’t borrowing won’t push up gilt yields

UK Economics Update
Written by Andrew Wishart

We doubt that the coming explosion in government borrowing or the accompanying rise in government debt will push up gilt yields. Low growth, low inflation, and low interest rates mean that they gilt yields will remain close to their all-time lows regardless of how credit rating agencies assess the health of the UK’s government’s finances.

  • We doubt that the coming explosion in government borrowing or the accompanying rise in government debt will push up gilt yields. Low growth, low inflation, and low interest rates mean that they gilt yields will remain close to their all-time lows regardless of how credit rating agencies assess the health of the UK’s government’s finances.
  • We expect the policy response to the coronavirus and the sharp fall in economic activity to cause the budget deficit to blow out from 2.0% of GDP to 10.8% of GDP in 2020/21 and government debt to rise from 77% to 104%. (See here.) Fitch have already downgraded the UK’s credit rating from AA to AA- and other credit ratings agencies will probably follow. But neither the sharp deterioration in the public finances nor ratings downgrades will significantly push up gilt yields for three reasons.
  • First, ratings downgrades don’t force investors to sell gilts. Sovereign debt issued in a country’s own currency always carries a risk weight of zero for regulatory purposes. And gilts are still rated well above junk so there hasn’t been any mandated selling due to asset managers’ internal rules.
  • Second, there is little need for investors to demand a larger risk premium to compensate them for the possibility that the UK defaults. After all, the UK issues its own currency so if push came to shove it could print money to pay back creditors. And the Bank of England has made it clear that it will do whatever it takes to keep yields low in the near term. As a result, the credit default swap premium on the 10-year benchmark has only risen to 40bps as opposed to 70bps in 2016 and 160bps in the Global Financial Crisis.
  • The fact the UK could print money to finance government debt might worry investors that the UK could surreptitiously default through high inflation, as this erodes the real value of nominal gilts. Indeed, some argue that after the crisis passes, very loose fiscal and monetary policy will stoke inflation.
  • But the third reason we think gilt yields will stay very low is that we expect inflation to be very low. (See here.) Fiscal stimulus has failed to raise inflation at the best of times (for instance the Trump stimulus in the US) let alone when the economy is in a slump. The slight fall in the spread between the yield on a nominal gilt and an inflation-linked one suggests investors agree with us that inflation is likely to be lower over the next decade as a result of the coronavirus crisis, rather than higher. (See Chart 1.)
  • Most importantly, gilt yields are determined by the economic fundamentals, not the whims of ratings agencies. Over the past decade there has been a pattern of government bond yields being lower after ratings downgrades than beforehand. (See Chart 2.) This is not just the case in the UK, but also in the US, Canada, and Australia.
  • Our forecast that GDP will take a couple of years to recover fully from the coronavirus crisis (see here), that inflation will fall below 1%, and that interest rates will stay at 0.10% for at least a couple of years mean that we expect the 10-year gilt yield to remain very low. Our forecast is that it will edge down from 0.33% now to 0.25% and stay there through to the end of 2021.

Chart 1: US & UK 10-Year Inflation Compensation (%)

Chart 2: 10-Year Gilt Yield (%)

Source: Refinitiv

Sources: Fitch, Refinitiv, Capital economics


Andrew Wishart, UK Economist, +44 7427 682 411, andrew.wishart@capitaleconomics.com