Trea­sury’s aus­ter­ity hawks risk push­ing the UK into Ja­panese-style de­fla­tion trap

The Daily Telegraph - Business - - Front Page - By Am­brose Evans-Pritchard

BRI­TAIN has seen a more dra­matic lurch to­wards neg­a­tive bond yields than any other ma­jor coun­try since the on­set of Covid-19, rad­i­cally trans­form­ing the struc­ture of the UK debt mar­ket al­most overnight.

Bank of Amer­ica says yields on £450bn of ster­ling sovereign debt have fallen be­low zero for the first time in his­tory. The speed of the move has been breath­tak­ing and sig­nals the real risk of a Ja­panese-style de­fla­tion trap for the UK econ­omy.

It comes de­spite a bud­get deficit ex­plod­ing to­wards £400bn this financial year. The sil­ver lin­ing is that the Trea­sury can cover the im­me­di­ate cost of the Covid-19 shock with­out hav­ing to worry about an ex­o­dus from gilts.

UK sovereign debt is trad­ing at neg­a­tive yields all the way out to seven years’ ma­tu­rity, repli­cat­ing the pat­tern in the euro­zone over the last four years. Two-year gilt yields fell to mi­nus 0.13pc last week, briefly drop­ping be­low com­pa­ra­ble Ja­panese lev­els. High grade cor­po­rate debt in the UK has been march­ing in lock­step, with bor­row­ing rates rapidly hon­ing in on zero.

Bond yields have been slip­ping across the world as debt mar­kets price in a trun­cated U-shaped re­cov­ery from the pan­demic, one that may en­tail a long painful re­turn to nor­mal once house­holds and firms start to tighten their belts. The mes­sage from the bond

vig­i­lantes is in a stark con­trast to nearper­fect V-shaped re­cov­ery priced in by ex­u­ber­ant equity in­vestors.

Over $12.4 tril­lion (£9.8 tril­lion) of global debt is cur­rently trad­ing at neg­a­tive yields but the fig­ure is still $2 tril­lion shy of last year’s peak. It is Bri­tish debt that has been “rerated” most sud­denly, con­verg­ing with the “Ja­panese bloc” since April. “The stand-out has been the UK,” said Barn­aby Martin, Bank of Amer­ica’s credit strate­gist.

The plunge in yields can be read in dif­fer­ent ways. The Bank of Eng­land is soak­ing up the en­tire debt is­suance of the Trea­sury, dis­tort­ing price sig­nals. The US Fed­eral Re­serve and the Euro­pean Cen­tral Bank are do­ing much the same thing in their re­spec­tive zones.

The Bank of Eng­land has opened the door to sub-zero pol­icy rates un­der An­drew Bai­ley, the new Gov­er­nor. “They al­ways used to say neg­a­tive rates are ‘not for us’ so this is po­ten­tially a big change to the tool­kit,” said Mr Martin.

Mar­kets are also an­tic­i­pat­ing a switch to Ja­panese-style “yield con­trol” by a string of cen­tral banks, the last step on the path to to­tal financial re­pres­sion.

How­ever, there is a much darker side to this bond rally. Ear­lier bouts of quan­ti­ta­tive eas­ing led – para­dox­i­cally – to a jump in global yields. In­vestors an­tic­i­pated an ac­cel­er­at­ing re­cov­ery and a re­vival of fu­ture in­fla­tion.

Some­thing has changed. The law of diminishin­g re­turns may have set in or the debt shock from the pan­demic has sim­ply over­whelmed the stim­u­lus. “The mar­ket is telling you that there is not go­ing to be a V-shaped re­cov­ery,” said Mr Martin.

The dif­fer­ent pat­tern this time is omi­nous, and no more so for Bri­tain, where loose talk of aus­ter­ity is al­ready start­ing to in­fect sen­ti­ment. The Of­fice for Bud­get Re­spon­si­bil­ity said last week that the UK pub­lic fi­nances are on an “un­sus­tain­able path”. It mapped out a bleak fu­ture of aus­ter­ity, in­clud­ing £60bn of prob­a­ble tax rises. An in­ter­nal doc­u­ment from the Trea­sury in May floated a pub­lic-sec­tor pay freeze, cuts in spend­ing, and tax rises, to­gether worth £25bn to £30bn a year.

The rhetoric from the Trea­sury and the OBR sug­gest that the ide­ol­ogy of the UK pol­icy es­tab­lish­ment has not changed over the last decade. This is de­spite crit­i­cism that aus­ter­ity was pre­ma­ture and pushed be­yond the ther­a­peu­tic dose (es­pe­cially cuts to pub­lic in­vest­ment), and there­fore proved self-de­feat­ing even on its own terms. “It seems the ‘Trea­sury view’ is alive and well,” said Pro­fes­sor Roger Farmer from the Na­tional In­sti­tute of Eco­nomic and So­cial Re­search. “A tax hike in the current cli­mate will in­flict un­nec­es­sary dam­age.”

The im­me­di­ate worry is that bond mar­kets may al­ready be act­ing on UK aus­ter­ity sig­nals, pric­ing in a de­fla­tion pathol­ogy that then be­comes self-ful­fill­ing and po­ten­tially dan­ger­ous. The risk is un­in­tended mon­e­tary tight­en­ing where in­fla­tion ex­pec­ta­tions col­lapse even faster than the Bank of Eng­land can keep stim­u­lat­ing the econ­omy. This has the ef­fect of lift­ing the “real” cost of bor­row­ing, even as con­di­tions de­te­ri­o­rate.

For in­vestors, global “Ja­pan­i­fi­ca­tion” cre­ates its own op­por­tu­ni­ties as well as dis­as­trous pit­falls, judg­ing by moves on the Tokyo ex­change over the last twenty years. Bank equities have been in a slow death spi­ral ever since the zero-rate era be­gan, drop­ping 70pc with tor­rid cycli­cal ral­lies along the way. Real es­tate has fallen 20pc.

Health­care stocks have soared 300pc and gov­ern­ment bonds have racked up 170pc over two decades. “The mar­ket will place great value on com­pa­nies that gen­er­ate sta­ble prof­its with low earn­ings volatil­ity. In Europe, we find that the ‘Ja­pan­i­fi­ca­tion’ bid is likely to grav­i­tate to­wards euro util­i­ties, health­care, tele­coms and con­sumer sec­tors,” said Bank of Amer­ica.

The other Ja­pan­i­fi­ca­tion win­ner is cor­po­rate credit. Bank of Amer­ica says yields will keep drop­ping as in­vestors try to es­cape the “no-go zone” of sub­zero rates.

The Euro­pean Cen­tral Bank has sig­nalled that it will buy many more in­dus­trial and com­mer­cial bonds (though not bank bonds), mak­ing the trade al­most ir­re­sistible for fixed in­come funds. Some €160bn (£145bn) of Euro­pean com­pany debt is trad­ing at neg­a­tive yields. “We think it will go to €500bn soon,” said Mr Martin.

Whether free loans for com­pa­nies ac­tu­ally lifts the real econ­omy off the reefs is an­other mat­ter. Fis­cal pol­icy is the name of the game now. The omens are mixed.

‘They al­ways used to say neg­a­tive rates are “not for us” so this is po­ten­tially a big change to the tool­kit’

The Bank of Eng­land has opened the door to sub-zero rates un­der its new Gov­er­nor

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