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UK Economic Outlook: Bond Vigilantes

17 November 2020

We hope you are all keeping safe and well during this second lockdown.
It might seem like an age ago, but bond yields increased steeply in 1994 fuelled, in-part, by the government deficit. Bill Clinton’s advisor, James Carville, said,  "I used to think that if there was reincarnation, I wanted to come back as the president or the pope... But now I would like to come back as the bond market. You can intimidate everybody.”  In the years that followed, the US turned a 3% deficit into 2.3% surplus, based on a fiscal policy aimed at reducing deficits so that bond yields (the cost of government borrowing) would come down. So far, so orthodox.
It is astonishing now how small these numbers seem in the context of more recent deficits.  In 2010, the UK and US ran deficits of 10.2% and 8.7% of GDP respectively – and yet yields continued to fall.  Indeed as most trustees will know, yields have been falling for the best part of 20 years.  Since the start of 2000, 10yr ‘real’ yields in both the UK and US have fallen by around 5% - in the UK’s case from 2% to -2.8% and in the US from 4.4% to -0.8%.  And yet during this period the debt to GDP of the UK has risen from 30% to over 85% (in 2019) and in the US from 56% to 107% (in 2019).  Both of these figures are likely to be significantly higher for 2020 once pandemic spending has been taken into account with estimates for the UK debt to GDP now comfortably over 100%. So governments are borrowing more, having been bingeing for the last decade, and are being charged less and less for it.
It certainly seems therefore that markets have left the orthodox view behind. They do not seem to care about deficits anymore.  The levels at which deficits and debt to GDP ratios are seen as being problematic, at least for developed countries that issue debt in their own currency, is significantly higher than it was 20 years ago.  However there are specific reasons why this is the case for now, and that if these reasons were removed, deficits could once again become a live issue forcing governments to make some very painful fiscal decisions.
One of the main reasons that deficits matter less right now is low inflation.  Low inflation has allowed central banks to keep interests rates low and thus debt servicing costs low.  With lower servicing costs, governments can run much high debt levels than previously (think about this in terms of how ‘affordable’ ever larger mortgages have become in recent years).  Low inflation itself has been the product of globalisation: mainly increasing manufacturing capacity in China which has lead to lower costs of goods. Developed countries have therefore been ‘importing deflation.’ The same argument applies to quantitative easing. Low levels of inflation have enabled central banks to expand balance sheets and purchase government debt.  This, of course, has been even more consequential in ensuring that markets don’t care about deficits.  If the largest single buyer of government debt is agnostic to debt levels then this obviously provides a significant safety net for governments.  Another reason is the structural demand for safe assets.  This comes from three main sources, all of whom could be termed forced buyers to a greater or lesser extent. 
Firstly, these are the UK DB pension funds.  Valuation methodologies more or less force pension funds to hold a large amount of risk free assets in their portfolios. The same is true of banks which, since 2008, have been forced to increase their holdings of liquid, low risk assets.  The third source is China, which (in order to invest its current account surplus and in order to maintain a competitive exchange rate against the dollar) were large buyers of US treasuries.
So where does this leave us?  It is clear that James Carville would have been very disappointed if his wish had come true.  But whilst there are reasons why deficits don’t matter right now, there are likely limits to how forgiving markets will be.  Indeed, we saw a glimpse of this in March; as the economic impact of the pandemic became clear, markets realised that economies would slow to a crawl or be shut completely, and that government borrowing would have to rise.  UK and US bond yields, having previously fallen as investors sought a safe haven, started to rise rapidly. Eventually central banks came to the rescue with announcements of more QE, but this incident showed that absent one of the factors mentioned above, markets do still care about deficits (albeit not as much as they do about trillions upon trillions of stimulus).
From an investor perspective it is hard to know how to react to this apart from to understand that the current situation may not last forever and shifts, when they do come, can be sudden.  We do not expect yields to rise significantly soon, government and central banks have too much at stake to allow that to occur; but as pension hedging levels have increased over these last 10 years in particular, the operational concerns around the extent of leverage should begin to be tested for some of these scenarios. There are many things which are – rightly – taking priority of trustees in these times, but it is inevitably these bigger questions, if left unprepared for, that can rapidly move up the risk register.
On a more cheery note, November is shaping up (so far) to be a good news story for our last piece of 2020!

The author

Robert Scammell

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