UK government bond market strong

The UK government bond market has been
one of the best performing of the year because the country is safely outside
the troubled eurozone and has its own currency, according to the man
responsible for managing Britain’s debt.

Robert
Stheeman, chief executive of the UK Debt Management Office, says: “We have an
independent currency. It is one of the reasons why the UK has outperformed
other bond markets.”

Although
Mr Stheeman refuses to criticise the monetary union project, he points out that
gilts have been helped by a weaker pound in contrast to countries such as
Greece and Portugal, which do not have the luxury of devaluing their currencies
to boost their economies through cheaper exports.

“The
gilts market benefits from a freely convertible and floating exchange rate,
which means that international investors will participate in our market,” he
says. “Often when sterling weakens, we see buying as gilts are cheaper for
foreign investors.”

This
combination of weaker sterling, which has fallen 6.2 per cent against the
dollar this year, and the British currency’s new-found status as a haven
outside the eurozone, has prompted flows into gilts, with international
investors buying record amounts.

Gilt
yields, which have an inverse relationship with prices, have fallen 20 per cent
to 3.35 per cent since the start of the year. Since the May 6 general election,
they have even outperformed German bunds, the traditional haven in times of
stress.

The
travails of the eurozone and relative success of the UK bond market have
reduced the already slim chances of Britain joining the euro to non-existent
under the Con-Lib coalition.

Although
Nick Clegg, Lib Dem leader, supports Britain’s participation in the euro in
principle, the policy is an electoral liability on the doorstep and he was
happy to sacrifice it during coalition negotiations in May.

He
acknowledges that Britain’s monetary independence has helped to cushion the
shock of the financial crisis. Like Mr Stheeman, he singles out the depreciation
of sterling, which has aided the economy by boosting exports as well as
encouraging international investors to buy gilts.

Foreign
investors bought £48.5bn of gilts in February, March, April and May – a record
for a four month period, according to the Bank of England.

This
interest from overseas has pushed down the average cost of borrowing for the
government to record lows of 3.21 per cent.

This
is important as it eases the pressures on the UK’s debt-burdened public
finances, which are at historical highs. Gilt issuance is forecast to rise to
£165bn this year. Last year it saw a record £227bn.

The
DMO, which was created in 1998, only saw £8bn in gilt issuance in its first
year, while the government’s average cost of borrowing at that time was 5.6 per
cent.

The
market has also been boosted since the emergency Budget, with gilt yields
dropping further as the government has convinced investors that the risk of the
UK losing its triple A rating has fallen.

By
pledging to tighten fiscal policy by £113bn over the next five years, the government
gained approval from the ratings agencies that it was not about to risk its
credit status and was determined to cut the budget deficit.

However,
the big question is can gilts continue to shine?

Certainly,
there are no signs yet that they will lose their attraction as the eurozone
crisis looks no closer to easing as the bond markets on the continental periphery
continue to take a pounding.

The
cost of borrowing for Greece, Portugal and Spain, the peripheral economies most
under pressure from the crisis, has risen to the highest levels since the
€750bn rescue package was launched on May 10.

And
even though sterling has strengthened against the euro in recent weeks, it is
still around levels considered fair value by most analysts.

A
leading banker says: “The market recognised the importance of a sovereign
nation being able to issue debt in its own currency as it means that monetary
policy is aligned to that economy’s bond markets.

“Some
of the eurozone countries are in effect issuing in a foreign currency. This is
because there is a monetary policy that does not bear any relation to their
macro-economic needs.”

Spain
and Ireland, which are seeing deflation in their economies, would benefit from
even looser monetary and fiscal policy, whereas Germany, the eurozone’s
strongest economy, is seeing signs of a pick-up in demand.

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