Evercore Pan Asset

The UK government bond bubble is currently growing large. The government probably wants this to happen, as it knows it has a lot of government debt to sell. But at some point investors and regulators will wake up and see it is not healthy for too many institutions and people to be lending to the government for low rates of interest (gilt yields: short 2.0%, medium 3.1% and long 4.0%), especially if the aim is to inflate their way out of the crunch in due course. For the moment the government can inflate the bubble more – after all there is still a positive rate of interest on longer bonds, and short term interest rates are still above zero. The government is succeeding in taking the available cash at a time when the corporate bond market needs it, and when the differential between government borrowing rates and corporate borrowing rates is very large and in the government’s favour.

So why does the bubble matter? Lending too much to any company or institution, as we have seen in the private sector in recent years is not healthy and at some point has to be corrected. All the time they can get easy credit they are happy and the system looks stable. Once they cannot get the credit any more people are amazed at how much they were allowed to borrow on such good terms in the good times. The private sector went to the borrowing party in 2005-6. The Bank of England supplied the liquidity, and the banking regulator had to implement the Basel rules which encouraged off balance sheet expansion. We are all now living with the consequences.

Now the government has invited itself to a similar party. The liquidity is once again being supplied by the Bank helped and encouraged by the Treasury, with assistance from the other banks and pension funds. The regulator is consulting on changing liquidity rules to make commercial banks lend more to the government (to improve their liquidity). The government has put in a new policy called “strengthening the banks” which entails putting taxpayers cash into some of the banks as Preference capital, so they can lend it back to the government at a running loss.

The foreign exchange markets currently do not approve. Maybe they have read the detail of the Chancellor’s statement and do understand that this year’s borrowing is not £78 billion as advertised but a massive £157 billion or more than 10% of National Income. Maybe it is just the advertised promise that the government will borrow 8% of National Income next year that worries them. Maybe it is that and the weak performance of the UK economy, though Euroland and the US will not perform well either. Maybe it is thinking ahead to the losses about to be recorded by UK banks, including those that the government has invested in. Whatever it is, something has spooked the currency markets. Sterling hit $1.45, 131 yen and 1.03 Euros yesterday. The slide continues unabated.

So what should the government do about the runaway borrowing, the bond bubble and the collapse of the currency? It could:

1. Signal that interest rates have fallen enough.

2. Cancel the proposed regulatory requirement for banks to buy more government bonds

3. Relax regulatory capital requirements on the banks as they declare write offs and create more realistic balance sheets

4. Start to cut the nationalised banks costs – they need to make some money to offset the losses

5. Indicate there will be no more government share capital for banks – future support for banks will be based around short term loans against proper security

6. Look for ways to get its capital back from the banks it has put share money into – through asset sales, cash sweeps and refinancings

7. Cancel the VAT reduction, and replace it with cheaper better targeted recession busting tax reductions

In the meantime the gap between the yield on corporate bonds and that on government bonds looks high. Of course there will be more bankruptcies and refinancings ahead for the corporate sector, as trading is very weak for many and the New Year will bring us more bad news. Any investment in corporate bonds needs to take into account the possibility of rapid fall from grace of some large companies, and the general hostility of the economic climate worldwide. However, as interest rates fall and yields on government bonds grow smaller the relative attractions of corporate bonds increase, chosen on a portfolio basis from amongst the stronger companies. It is also possible to use overseas corporate bonds to give funds more exposure outside sterling all the time the government ignores the fall of the currency.