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