Today’s UK Autumn Statement could conceivably tarnish the growing reputation of gilts as a safe haven.
But while official projections for public borrowing are likely to be revised higher in response to weaker economic growth, there is little chance of a volte-face in fiscal policy that would fray bondholders’ nerves. In fact, with stresses in the eurozone’s core building, gilts could see further inflows of capital from foreign investors in search of sanctuary.
Gilts are clearly not immune to fiscal concerns. Indeed, investors have become progressively more worried that borrowing will not fall in line with the government’s fiscal plans so long as growth remains weak – the cost of insuring against a sovereign default over the next five years has risen significantly since the spring and currently stands at its highest level since April 2009.
But while the UK public finances are still in a mess, at least investors do not have the survival of sterling on their minds. The same cannot be said of the euro, the future of which is likely to depend on whether Germany is prepared to save her weaker neighbours. A growing belief that she may choose this path has pushed up the cost of insuring against a default by her government to a level that now exceeds that of insuring against a default by the UK government.
Of course, if Germany decides to play hard ball, investors may become less concerned about her own fiscal predicament. But this attitude would simply reinforce the impression that she was unwilling to prevent a disorderly break-up of EMU. In that scenario, it seems very likely that investors would want to give the whole of the eurozone, including Germany, a very wide berth.
Indeed, we suspect this concern has been a key factor behind the recent weakness in Bunds, which have previously been a major beneficiary of foreign capital in search of a “safe” home. By contrast, non-resident investors’ appetite for gilts has generally waned this year, suggesting that there is more scope for the UK government bond market to become an alternative repository for risk-averse investors.
In the meantime, gilts should continue to benefit from exceptionally accommodative monetary policy as an antidote to tight fiscal policy. Admittedly, the prospect of an extended period of ultra-low interest rates should support Bunds, too, although probably without the additional benefit of quantitative easing.
But overall we think the outperformance of gilts relative to Bunds is likely to continue.
By John Higgins at Capital Economics
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