Gilt market stutters on spending cut plans

The government’s planned spending cuts are expected to be deemed a credible path to consolidation by the ratings agency, but there are concerns that the good news is more than priced in.

The yield on the benchmark 10 gilt fell to 3.4% at the start of at the start of the Budget speech, but had risen to 3.45% by the time chancellor George Osborne sat down.

The market’s main concern is that the Office for Budget Responsibility’s growth forecasts are too high despite revised down for next year.

Marc Oswald, strategist at Monument Securities, says: ‘The fundamental problematic remains that the GDP forecasts look to be too optimistic by roughly 0.3% to 0.5% per annum, i.e. for this year we would expect GDP to be around 1.0%; while for 2011-2015, GDP seems more likely to be in the 2.0-2.5% range rather than the 2.5%-3.0% range that this Budget assumes.’

Further problems in the gilt market could also be in store.

On the one hand Osborne is backing the ‘Rubinomics’ approach of taking the fiscal pain upfront to avoid a double dip recession.

Under President Bill Clinton in the 1990s, secretary of the treasury Robert Rubin implemented swingeing public sector spending cuts while keeping the markets happy and maintaining low interest rates to help manage the cost of its debt burden.

Royal London Asset Management’s Ian Kernohan says the coalition government is adopting a similar approach.

‘The government’s view is that is better to deal with the deficit now and ensure gilt and yields and interest rates remain low,’ he says. ‘It is arguing that it is better in the long-run for the recovery and do not want to risk losing its high credit rating.’

The amount of issuance over the next few years is also to be reduced with planned gilt sales in 2010-11 are being reduced by £20.2 billion to £165 billion with three of the planned 52 gilt auctions being cancelled.

But Oswald says that the government’s message of ‘don’t worry there will still be plenty of gilts to buy’, somewhat misses the point. He points that quantitative easing mopped up most of the issuance in the last fiscal year with little net new investor cash coming into the market. When greater clarity emerges on just how much the banks will have to hold for their capitalisation purposes, some are likely to have bought too many and so become net sellers.

‘As far as the rating agencies go, we could expect this Budget to be termed ‘a credible’ path to fiscal consolidation,’ the interesting aspect will be whether S&P retains its ‘negative outlook’,’ he says. ‘We remain of the view that with current 10 year yields below 3.5%, the US/UK gilt yield spread at 24 basis points and the Bund/gilt spread at 68 basis points, all the good news is more than priced in.’

It appears that the market agrees and although the spending cuts detailed in the Budget may have more or less appeased it for the time being, gilt buyers will from now on be basing the success of the coalition on its results not talk.