Brexit-Bound U.K. Puts Gilts in Jeopardy in Fiscal-Stimulus Test

(Bloomberg) --

A ripple of negative reaction across U.K. government bonds may be a taste of what's to come as the country heads for one of Europe's first major tests of fiscal stimulus.

The policy, long-advocated by central banks, could emerge in the first finance bill to be presented in Westminster after Brexit, on March 11. Prime Minister Boris Johnson's budget may focus global attention on the potential for expanded government spending to boost growth, as well as the market's appetite for greater bond supply.

There was a first glimpse of how that could be received on Tuesday, when the Debt Management Office said gilt sales will increase by 14 billion pounds ($18 billion) in the 2019-2020 financial year. Afterward, 10-year U.K. securities led declines in Europe for a time. But the selling faded after the Britain's first auction of 2020 was oversubscribed by almost two-and-a-half times the amount on offer.

The U.K. budget's impact on the economy will be closely watched, not least at the ECB. Christine Lagarde, its new president, has struggled to round up support to move the main source of stimulus away from monetary policy and toward government spending. Germany in particular is reluctant to end its balanced budget policy, while Italy's attempts to lift spending have faced resistance from the European Commission.

In the U.K., there will be greater leeway on spending after policy makers overhauled fiscal rules, marking the end of Britain's period of austerity.

“The Conservative Party is hardly going to be profligate but compared to the fiscal stance of Germany, we could probably see a higher chance of a pro-growth stance in British spending policy,” said Koon Chow, a strategist at Union Bancaire Privee.

“It's quite likely the U.K. could could need fiscal stimulus as longer-term growth challenges persist, not least of all from likely long-term weight on services trade, of which there has been little or no discussion in the Brexit talks.”

An increase in issuance may have implications for the spread between gilts relative to interest-rate swaps, known as swap spreads, which provide one of the clearest insights into how investors are pricing in fiscal stimulus.

What Bloomberg Intelligence Says

“While an increase in net gilt supply can put modest narrowing pressure on swap spreads, in order to have a more sizable impact in the near-term, the government will have to break its re-drawn borrowing limit and accelerate any new infrastructure spending. The BOE's reinvestment of gilt redemptions, due in March, may pose a risk to spread narrowers. The share of linker issuance remains on a downward trend with no planned increase and is also probably reflective of concerns about demand ahead of the RPI reform consultation.”

-- Tanvir Sandhu, Chief Global Derivatives Strategist

Meanwhile, the chances of a rate cut from the Bank of England, which would be supportive for gilts, are declining, with incoming Governor Andrew Bailey seen as having less room to act as Brexit uncertainty lifts and economic data brightens. Money markets on Wednesday were pricing in a 52% probability of a quarter-point interest-rate cut from the U.K. central bank by the end of December 2020, compared with 56% at the start of the week.

That comes while the U.K. is able to borrow over 10 years at a yield which is around 100 basis points below that on equivalent U.S. debt, a sign that Britain has fiscal room. While it seems clear the gilt market will face increased supply, there are some doubts about the depth of the potential impact.

Chris Jeffery, head of rates and inflation strategy at Legal & General Investment Management, says the chancellor's redrawn fiscal boundaries imply additional gilt issuance of around 20 billion pounds per year, if taken to their new limit.

“That additional stimulus will help boost the growth outlook, but it is hardly transformative,” he said.

The fate of fiscal stimulus in the U.K. is likely to depend on the final details of its future trade relationship with the EU, due to be finalized by Dec. 31.

“More major fiscal stimulus could be required in 2021 or beyond, should the U.K. leave the transition period without a free trade relationship with the EU, and if economic activity slows materially,” said Howard Cunningham, fixed income portfolio manager at Newton Investment Management.

“With manifesto pledges having effectively closed off major tax-raising avenues, the bulk of the additional financing would have to come from debt issuance,” he said. “Although the government views this outcome as unlikely, they are unlikely to use up all their fiscal firepower ahead of this.”

--With assistance from James Hirai.

To contact the reporter on this story: Michael Hunter in London at mhunter72@bloomberg.net

To contact the editors responsible for this story: Dana El Baltaji at delbaltaji@bloomberg.net, William Shaw, Mark Tannenbaum

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