There has been a substantial flow of funds into the UK government bond market over the past few weeks with a shift of eurozone funds into the relative safety of the UK as the euro area threatens to implode. The importance of these capital inflows has been illustrated by the decline in benchmark yields to record lows with 10-year UK bonds yielding close to 2.2% while Spanish yields, for example, have moved above the 6.5% level.
It will be extremely difficult for the British Pound Sterling to sustain international confidence, particularly with the economy at a crucial pivot point as it threatens to tip back into recession. The net outcome is likely to be substantial downward pressure on sterling with a decline to at least 1.50 against the dollar this quarter and the risk of a further slide toward 1.40 in early 2012.
There is very little to celebrate in the UK economic outlook with business and consumer confidence under sustained pressure. There was GDP growth of 0.5% for the third quarter, but confidence as deteriorated again since then with the Nationwide consumer confidence index, for example, at a record low. There will be an important negative impact from eurozone weakness, especially with exports already showing signs of vulnerability. The Bank of England was notably downbeat in its latest inflation forecast with a further downgrading of 2012 growth prospects with expansion of only 1.0% for the year as a whole from 2.0% previously. There was also a clear hint that further quantitative easing will be announced soon.
Interest rates are already very negative in real terms and there will only be a partial improvement once inflation falls in 2012, which makes the low level of UK yields even more remarkable.
The decline in bond yields will certainly be extremely welcome news for the UK Treasury as it will have an important impact in curbing debt-interest payments.
The other pressures on the UK fiscal outlook will be substantially less favourable as rising unemployment will put upward pressure on welfare payments. There will also be an important impact from the inflation-linking of benefits given that the inflation rate is above 5%, although the government has hinted that future upgrades may be scaled back.
What is clear, beyond doubt, is that the government’s current economic policies will not survive if there is another recession in the UK. To maintain downward pressure on the deficit, the government would have to put another severe squeeze on spending, especially as automatic fiscal stabilisers would kick in and push the nominal deficit higher.
There is an important irony in Sterling’s recent gains. There have been capital inflows on the basis that the UK will not default, in contrast to fears surrounding the peripheral eurozone economies. It is certainly the case that the UK is exceptionally unlikely to default, at least in the short term. Nevertheless, the alternative medium-term path to sustainability will be debt monetisation. One way or another, to avoid default, the UK will have to inflate the debt away and this will have extremely negative medium-term implications for sterling.
The UK has had some success in narrowing the budget deficit, but it is still close to 10% of GDP on an annual basis and remains at an unsustainable level. The overall UK debt burden, once the household and financial sector is included, is estimated to be over 400% of GDP, worse than Greece or Spain. Sterling will be very vulnerable if underlying risk appetite deteriorates further.
The banking sector will be an extremely important focus and there will be renewed fears over lending as banks shrink their balance sheets, especially as the sector has never recovered from the 2008 crisis. Money supply growth also remains extremely weak and is a clear sign of distress within the banking sector. Given the overall UK debt burden, it is extremely doubtful whether overseas confidence in sterling assets will hold firm for much longer as all possible favourable developments have already been priced in.
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