Monday, June 21, 2010
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...