Friday, February 05, 2010

Blood in the water

Blood in the water

Back in December I posed the following question:

The only net buyers of UK gilts this year are the Bank of England (through Quantitative Easing) and UK banks, thanks to a Govt. requirement to improve their capital adequacy.  Fund managers and overseas investors are net sellers.  When QE stops, who is going to do the buying?  And at what price?

Well, QE has just stopped – for the time being at least.  So it looks like we’re going to find out.  The initial prognostications are not good, to say the least.

Managers like Threadneedle, Schroders and Sarasin are underweight, short duration, or shorting UK gilts, concerned that as the BoE ceases quantitative easing (QE) and issuance builds, buyers will refuse to play ball.

"The market has moved to a defensive posture," said Quentin Fitzsimmons, executive director, fixed income, Threadneedle. "If investors go on a buyers' strike, prices could fall sharply and yields could rise."

If investors go on a buyers' strike then we are all in a lot of trouble.  Have a look at this (horrifying) chart of sovereign risk – what’s really noticeable is that the UK deficit is up in a toxic group of four – Spain, Greece, Ireland and us.  Why are we the odd one out there?  The others have all had their credit ratings downgraded.  The markets simply will not continue to view this sort of deficit with equanimity: the UK is beginning to look like a really bad risk.  Once that happens, the spiral is quick and painful.

The Keynsian argument that a recession is the worst time to cut spending remains as true as it has ever been.  Unfortunately the counter-argument – that if we do not cut spending our debt will be down-graded making it more expensive to borrow,  meaning that we will have to borrow even more – is coming ever more sharply into focus.  As Churchill said:

You cannot ignore the facts, for they glare upon you.

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