Gilt prices fell sharply yesterday as investors began to digest the Government's pre-Budget report (PBR) and fears that Britain's credit rating will be downgraded intensified.
Yields on 10-year gilts had risen by 14 basis points by the end of the day as confidence in Government debt spiralled downwards, dragging prices down with it.
So far, none of the three leading credit ratings agencies has made a public comment on Britain's sovereign debt following the Chancellor's speech on Wednesday. But the City is rife with speculation about whether Britain, with public debt at nearly £700bn and rising, can hang on to her prized AAA credit rating .
The gilts market is also pricing in concerns that Alistair Darling's forecasts of economic recovery may prove over-optimistic – and his public spending cuts too hazy – to bring the ballooning deficit under control.
There are two major worries, firstly the numbers. Mr Darling predicts that borrowing will hit £178bn this year and £176bn in 2010, but that the economy will grow by 1.25 per cent in 2010 and 3.5 per cent for the two following years, helping to bring borrowing down to £96bn by 2013-14.
But the accountant PricewaterhouseCoopers (PWC) published contrary estimates yesterday, predicting far slower growth after next year and borrowing totalling £777bn between this year and 2013-14, compared with the Chancellor's forecast of £707bn.
The differing estimates have major implications for the UK's credit rating. Using the Government estimates, net debt will peak at just under 78 per cent of gross domestic product (GDP) in 2015. But PWC's forecasts suggest the deficit could hit 80 per cent of GDP within five years. An even more bearish analysis from Citigroup expects it to hit 95 per cent by 2013 and 100 per cent soon afterwards. No country with a net debt/GDP ratio of more than 100 per cent has held on to its AAA rating with all three agencies.
The other problem for the gilts market is what the Chancellor did not say. Despite reiterating Labour's commitment to halve annual borrowing to 5.5 per cent of GDP in four years – a pledge soon to be enshrined in law – there was little detail about where the extra money will be found instead.
Analysts complained that, rather than giving hard answers about where public spending cuts would fall, Mr Darling stuck with commitments to ring-fence spending on schools, hospitals and the police. The lack of clarity fuelled scepticism that the Government has no credible strategy for getting its eye-watering debt back in line even if the growth predictions do turn out to be accurate. Alan Clarke, an economist at BNP Paribas, said: "Mr Darling missed an opportunity to provide details about where the spending cuts will be. The market was looking for specifics, instead it got political showboating and the Chancellor killing time."
Even the politics is a problem. With some pundits putting the chances of a hung parliament as high as 30 per cent, investors are also starting to fret about the implications of an unstable government that could struggle to set policy and force through potentially unpopular, cuts. Vicky Redwood, of Capital Economics, said: "A hung parliament will make it harder to get a consensus on how to cut the deficit."
The Chancellor's focus on politics in the run-up to a general election was expected and the ratings agencies have no explicit plans to review the UK's creditworthiness, but there has been some early sabre-rattling. Moody's published a report on AAA-rated sovereign debt two days before the pre-Budget report. Although most of its assessment of the UK focused on the "very high degree of debt financeability" and the public appetite for fiscal retrenchment, its sound a warning.
Pierre Cailleteau, managing director of Moody's sovereign risk group, said: "While assumed capacity for fiscal adjustment currently supports the maintenance of the AAA rating of the UK Government, this assumption will have to be validated by actions in the not-too-distant future to continue to provide support for the rating."
Sovereign debt downgrades are a real fear. Fitch Ratings downgraded Greece's government debt as well as five of the country's banks this week. Standard & Poor's has put Greece on a "negative" watch and also reduced its outlook for Spain and Portugal.
Interest rates and QE: Bank rules no change
Interest rates will remain at their record low of 0.5 per cent to give the teetering economy longer to recover from recession, the Bank of England's Monetary Policy Committee (MPC) decided yesterday.
The MPC also voted to stick with existing plans for quantitative easing (QE), under which a further £25bn of new money is being pumped into the economy via the gilt and bond markets, taking the total to £200bn.
Neither decision was much of a surprise to the City. Some analysts predict that QE might yet be extended, but it is unlikely to be considered before the current programme is completed in January.
And the expectation is that interest rates will remain low well into next year, if not beyond, as the Bank tries to counteract the tight fiscal policy the Government will have to run to get the public finances under control.
"With sustainable, significant recovery very far from guaranteed, any policy tightening still looks a long way off and we expect interest rates to stay down at 0.5 per cent until at least late-2010," said Howard Archer, the chief UK economist at IHS Global Insight. "Indeed, the Bank could very well delay raising rates until 2011."
Ian McCafferty, the chief economic adviser to the Confederation of British Industry, added: "Economic growth will be anaemic at best across 2010, so the Bank will have to continue looking to monetary policy leavers for some time yet, and interest rates are likely to remain low for some time."
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