BlackRock warned that the prospect of pre-election tax reductions and spending promises could lead to a return of “bond vigilantes”, and an increase in bond sales.
The asset manager said that the investor appetite for debt in developed economies remains at record highs, even before this year’s widely predicted interest rate reductions.
Vivek Paul is the UK chief investment strategist for BlackRock. He told Bloomberg that Labour or Conservatives may be more inclined to promise a looser fiscal policy. The more this happens, the higher the probability of bond vigilantes returning. We’re closely watching fiscal policy in the run-up to the UK election this year.
Bond vigilantes, or investors who dump sovereign debt in large numbers to increase yields, can drive up borrowing costs for governments. In the fall of 2022, the UK was punished by the financial markets when the yields of long-dated gilts (UK government bonds) rose to new highs due to Liz Truss’s promise of £50 billion of debt-financed tax cuts.
Paul wrote: “The autumn 2022 UK gilt crises still hangs over pre-election discussions so far,” Paul wrote. The Bank of England had to intervene and buy 30-year gilts in order to stop pension funds from selling bonds to raise money. Truss’s tenure in office lasted only 44 days.
Despite Paul’s warning, the demand for newly issued UK government bonds remains high. This is probably due to the significantly improved returns on offer for investors.
According to the Debt Management Office a £2,25 billion auction of gilts for 20 years with a yield 4.39 percent attracted bids of more than £8 Billion on Tuesday. This means that the sale was 3.6 times covered, which is the second highest bid-to cover ratio in history. In a day of record bond issuance, other major European governments such as Italy and Belgium received huge demand for newly-issued debt.
The UK’s public finances are under pressure as a result of higher interest rates on government bonds. In November, Britain spent £7.7bn compensating holders of debt. This was a record amount for the month. Investors may have been motivated to buy government bonds by the desire to lock in higher interest rates before central banks loosen monetary policy, which is widely expected.
After the official interest rate falls, there is a danger that governments may struggle to find new buyers for their debt. Quantitative tightening is also underway by the world’s leading central banks, which means that governments will be in a fierce competition to find buyers.
The Conservatives have hinted at tax cuts that will be announced in March. This is months before a possible general elections. Jeremy Hunt, chancellor of the UK, said last week it was too soon to estimate the amount of additional “headroom”, the government will need to fund its pledge to reduce the tax burden for households.
Both parties have been attacking each other over their fiscal plans. Labour has accused the government of continuing “Trussonomics”, with unfunded tax reductions. The Conservatives accused the opposition party of fiscal irresponsibility in relation to a proposed £28billion green spending fund. Labour now says that the fund will only be created if public finances permit.
Bim Afolami said that the warning from the asset manager showed “the bond market is clear: Labour can’t borrow to pay their £28 billion a year unfunded commitment without risking debt crisis.”
BlackRock has a “neutral” stance on UK gilts and is expecting interest rate reductions from the Bank of England in this year. BlackRock stated last month that “Gilt Yields have Compressed relative to US Treasuries, and Markets are Pricing in Bank of England Policy Rates Closer to Our Expectations”.
Interest rates falling are good for bond prices as they lower the yields of assets. The UK’s 10-year bond yield has dropped to 3.8 percent after reaching a peak of 4.7 percent last summer when persistently high inflation raised expectations of further monetary tightening.
The bond analysts at NatWest Markets are bearish on gilts. They warn that the 10-year yields will rise to 4% at the end of this year because of an increase in supply due to fiscal policy, and “some possible overestimation of demand by retail” as the Bank of England is unlikely to implement the estimated five rate cuts that traders have bet on.
Imogen Bachra of NatWest’s rates strategist said that the “top concern” among gilt investors was greater bond issuance. This would likely occur in the event fiscal tightening.