Monday, June 21, 2010

England vs France - Gilts to score in the final minute...

At the request of one of our readers, and with the UK Budget announcement tomorrow, we thought today was as good a day as any to do a piece on the UK's credit rating. A popular view, at least until the UK election, was that the UK would get downgraded as its budget deficit of 11% rivalled that of Greece, that the cost of bailing out the financial system would lead to a permanently higher debt-to-GDP ratio and that a hung parliament would result in a lack of political will to deal with the problem. Well, somewhat ironically, Gilts have been seen as something of a safe haven over the past month as investors have fled toxic waste Eurozone Goverment Bonds as well as the Euro and this has led to something of a re-rating of UK Gilts relative to the Eurozone. The chart shows Swap Spreads vs OIS for the US (white), Germany (pink), the UK (green) and the GDP-weighted average Eurozone (orange). But on an absolute basis, UK paper still trades significantly wider than USTs or Bunds and close to where the Eurozone debt (with an average rating of AA+) did prior to the crisis becoming systemic in April.

Team Macro Man holds a somewhat cynical view of the CDS market, and especially so of the Sovereign CDS market, where only a $50m clip can move the market. Against the vast size of the cash bond market, it is often a case of the tail wagging the dog. Indeed, Team Macro Man cannot help but laugh at the irony of various investment bank research pieces claiming that the CDS market is only a "mirror" for the underlying problems in response to claims by politicians that the CDS market is contributing to market volatility and compounding problems. Remember the cries of pain from banks, both present and deceased, that "evil short-selling hedge funds" were causing panic in their stock prices by shorting their CDS? It wasn't *that* long ago was it...?! Anyway, regardless of that point, the Eurozone crisis has at least led to a linkage between CDS prices and the underlying bonds. Looking at the Sovereign CDS spread of the OECD (plus a few other stragglers), we can see that the UK trades as if it were AA+, which is consistent with the above observation from swap spreads.

OK, so the market says the UK is something like AA+, and thus is pricing in the loss of the prized AAA-rating. But is it? Despite the Coalition hiking Capital Gains Tax in order to fund a LibDem pet tax-cut for lower income families, since the election, the message day in and day out has been that austerity is coming in a big way. The government has succeeded in persuading the public that this is the "last lot's fault" according to opinion polls and thus getting the dirty work out of the way early is order of the day. In line with various academic studies, the Tories have insisted on an 80-20 split for expenditure cuts vs. tax hikes, and as a result will have a high probability of succeeding in reducing the deficit. The Conservative election manifesto stated the intention to eliminate the structural deficit in the life of the Parliament and, versus the Labour budget in March and the OBR's appraisal of this last week, would imply another 2-3% of deficit cuts. The first chart below shows the Labour budget forecast for the cyclically-adjusted deficit (brown), the OBR's (green) and the path implied by the Tory manifesto (orange) and the second chart shows the equivalent net-debt forecasts.

Now, a stabilising debt-GDP ratio (above chart shows it stabilising at about 73% of GDP) coupled with growth by the end of the Parliament will be sufficient to maintain the AAA-rating as cyclical surpluses start to bring down the ratio. The below chart shows the long run Gilt swap spread vs. OIS (white line) against the budget deficit (orange line), and a fall in the deficit towards 3% of GDP implies that Gilts would trade a lot closer to where USTs and Bunds are vs. OIS.

The real question here is can they pull it off? Probably one of the main reasons why the UK has not already been downgraded is that it has a pretty successful history of pulling off budget cuts (see below chart of past budget retrenchments). In the 1980s and 1990s, especially, the debt-stock was significantly reduced at a time of very strong growth. Bears claim that austerity will crush growth but contrary to popular opinion, the UK economy had already exited recession when Geoffrey Howe announced his 1981 austerity budget: there was no double dip, and the economy grew above trend for several years. Some argue that this was because of FX depreciation or rate cuts - certainly they helped - but that was not the case in the 1990s when rates & the Currency were moving higher. The key here is business investment, which is crowded in as the government retrenches and was behind both the 1980s and 1990s expansions (see second chart below).

It looks to Team Macro Man that provided the Coalition can get their plans done that the UK will keep its AAA-rating, and that Gilts are likely to gradually richen.

Finally, Team Macro Man should probably mention what most of the market is talking about today: China trying to defuse the national protectionism that's becoming more evident in the US by smoke screening a change in FX policy. The Chinese have used their mastery in obfuscation to leave the market trying to second guess what is really going to happen. Their timing was superb too considering their "don’t let speculators make any money" policy. After the mayhem of May, the spec market had closed most of their core macro bets - including the perennial China play. This morning there are many portfolio managers left standing on the platform checking their watches as the train vanishes into the distance...


Игры рынка said...

This discussion of credit risk of a nation being sovereign in monetary sense has always been a non-sense. And it is quite a disappointment that Macro Team is falling into this trap. No nation which issues its own currency has any economic credit risk. Full point.

You can read thousands of words of non-sense from ratings agencies or anybody and realize they have no clue what they are talking about. It is absolute ZERO credit risk for any nominal obligation in the currency of issue for the issuer of an obligation.

_Credit_ rating agencies are completely unqualified to make ANY judgement for such nations.

CV said...


Watching the train you say ... I have been sporting a long position copper for a couple of months now and it is only now moving into black (I chose a horribel level apparently) so for me I am just entering the station :)

and no, I am not a PM, but merely dumb CFD retail, but it still counts ... ;)


Thorium238 said...

Thank you for your comment about the UK's zero credit risk because of its ability to print its own currency, do you own a wheel barrow manufacturer by any chance. And when have the markets ever let a simple thing like the truth get in the way of a profit making oppotunity!!!

cpmppi said...

Игры рынка:

While I agree with the broad principle, there are a few examples of domestic currency restructurings over the years, notably, Russia.

With respect to the ratings agencies, I completely agree. The above example was a case of "willingness to pay" not "ability to pay", and that is more a political issue than an economic one.

As an aside, the presence of an independent central bank theoretically remove the ability to inflate the debt away. Of course, the real question is "can a central bank ever *truely* be independent?". If it can, then domestic currency obligations definitely have credit risk. Of course, in reality, I do not think this could ever be the case. The Bundesbank got the closest to this, but I can't think of any other examples...

cpmppi said...


Yeah, Copper is interesting - something of a divergence with other risky assets.

I'm sure Nemo, our resident metals expert, will be able to comment further!


Игры рынка said...

cpmppi, Russia had a currency peg to USD and therefore politically was not sovereign in a monetary sense. Then IMF bullied them to default on RUB obligations instead of USD obligations which would have been the only sensible thing to do. This is precisely what Argentina did in 2001, i.e. told IMF to get lost. Why IMF did in Russia what they did is another question but the answer is very transparent.

Don't you think that an independent central bank is a absolute failure of democratic process? What makes you think that an electable government is always worse than a bunch of unelectable central bankers? Dang it. I trust noone these days but at least I can vote my government out next time which makes them run faster and care what people think.

And what is the motivation of a central banker? "I do not give a damn" is the best answer.

And then the story typically goes that people will vote for any populist idiot. But I will say that governments should invest into education to allow people to cut-off the sh&t early in the political process. Now compare this outcome to the typical budget process these days. Cut spending with education being on top of the list.

And here we are with stupid people and a bunch of unelectable and unaccountable central bankers running the whole world.

cpmppi said...

Whether they were pegged or not is irrelevant, as is whether or not the IMF twisting their arm, they still defaulted on the local ccy debt.

Perhaps democracy isn't such a good idea if it involves the electorate as a whole determining economic policy rather than those that have spent their entire life studying the subject. I would always rather be operated on by a qualified surgeon rather than a democratic committee of lay people. History suggests that people will always vote for more "free stuff", and rightly so - free stuff is great! But we know there is no free lunch and ultimately such policies end up with inflation. I don't think anyone would suggest that Argentina is a shining example.

Regarding the lack of accountability of central bankers, I agree it would be beneficial to benchmark them. Something along the lines of a statutory limit for the ex-poste standard deviation vs the inflation target that has been delevered sounds sensible. But having central bankers accountable directly to politicians or the electorate will merely result in the same inflationary consequences as above.

Игры рынка said...

cpmppi, remember that story: guns or butter? There is no free lunch by definition. Rather you have to make your choice and vote: more _educated_ surgeons (aka social security and medicare) or more wars in Iraq. Very simple!

Unfortunately for central bankers, they are not in the equation because they are irrelevant for the allocation of real resources. Central bankers are nominal!

And you seem to completely miss the point on what defines a sovereign country and what opportunities it gives. Simply check back when Greece finally defaults and US is still running its budget deficits without and doing what it can and should do to fight the crisis.

scepticus said...

"In the 1980s and 1990s, especially, the debt-stock was significantly reduced at a time of very strong growth."

For heavens sake, the strong growth was just a ponzi like re-leveraging of the private sector. M4 has grown practically non stop even in recessions for the last 30 years.

The current crisis is because of the failure to de-leverage (the whole economy) after the recessions of the 90s and 80s.

You think we can pull the same sh*t again? We shall see but I very much doubt it.

"The key here is business investment, which is crowded in as the government retrenches and was behind both the 1980s and 1990s expansions (see second chart below)."

Crowded in? Exactly how is anyone forced to invest in private business as the government retrenches? There is no forcing as the term 'crowding in' implies. In fact crowding in implies falling yields to me, much as 'crowding out' implies rising rates.

In which case, crowding in should lead to a liquidity trap no?

If not, why not?

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