Labour would probably borrow a lot more than the Conservatives if it won the election, but we doubt gilt yields would soar. Labour’s fiscal plans wouldn’t bring debt sustainability into question, inflation expectations are unlikely to leap and relatively low policy rates would anchor the short end of the curve.
- Labour would probably borrow a lot more than the Conservatives if it won the election, but we doubt gilt yields would soar. Labour’s fiscal plans wouldn’t bring debt sustainability into question, inflation expectations are unlikely to leap and relatively low policy rates would anchor the short end of the curve.
- There is little sign that gilt investors are concerned about a big fiscal stimulus in general. The Conservative and Labour parties have pledged rises in government investment of up to £20bn (1% of GDP) and £55bn a year (2.5% of GDP) respectively. But whereas gilt yields rose sharply in October as the risk of a no deal Brexit fell away, they have been little changed as the prospect of much looser fiscal policy has grown.
- As Labour is well behind in the polls, investors are probably putting little weight on an outright Labour victory. But the chances of a Labour-led coalition or minority government are a little higher. Seeing as Labour is promising a larger fiscal stimulus than the Conservatives, could tamper with the Bank of England’s independence and has little respect for investors’ property rights, this is a worrying prospect for gilts.
- But there are three reasons why gilt yields wouldn’t rise much. First, the policy rate would stay low. Admittedly, a Labour majority would provide a soft, if any, Brexit and a big fiscal stimulus which could prompt the Bank to raise rates. But its other policies would weigh on business confidence, as was the case when New Zealand elected a left-wing government in 2017. (See here.) A Labour-led coalition or minority government would also lead to a soft or no Brexit, and the Party’s more extreme policies would be shelved. But the fiscal boost would be tempered. So rates wouldn’t rise much in either outcome. We suspect they would fall from 0.75% to 0.50% in early 2020 as Brexit is delayed and then rise in 2021, perhaps to 0.75%.
- Second, gilt yields would not rise much relative to expected short rates because there is little risk of debt sustainability becoming a serious concern. Low interest rates mean governments can service much larger debt piles than before. Despite the rise in the debt ratio from 34% of GDP in 2007 to 84%, interest payments will cost the government just 2.2% of GDP this year. (See Chart 1.) In contrast, during the euro-zone debt crisis in 2011/12, Greece and Italy were spending 7% and 5% of GDP respectively on debt interest. For UK debt interest costs to reach a level that may concern investors, of say 4% of GDP, borrowing costs would need to rise by 2% and the debt ratio would need to climb to over 120%. Labour’s plans are within these limits as their policies point to a rise in the debt ratio to about 100%. And as long as investors feel gilts are safe, any rise in yields would probably be limited by the global search for yield. If Labour won the election, we think the spread of gilt yields over the policy rate would rise by only 25-50 basis points.
- Third, it is possible that the combination of a fiscal stimulus and concerns around the independence of the Bank of England under a Labour government pushes up long-term inflation expectations. But the US experience suggests this wouldn’t be the case. Despite President Trump’s large fiscal expansion and his attempts to influence the Fed, market inflation expectations in the US remain well anchored. (See Chart 2.)
- Overall, low official interest rates, well anchored inflation expectations and the limited risk to debt sustainability mean the election of a Labour government would not push up gilt yields much. We suspect the 10-year gilt yield would only rise from 0.70% now to around 1.25% by the end of 2021.
Chart 1: Government Debt Servicing Costs & Gilt Yields
Chart 2: US 20-Year Inflation Swap Rate (%)
Sources: Refinitiv, Capital Economics
Sources: Refinitiv, Capital Economics
Andrew Wishart, UK Economist, +44 20 7808 4062, email@example.com