Gilt market is depriving the UK economy the capital it needs

Writing about bonds – the IOUs issued by governments and companies – is the journalistic equivalent of a black hole. Cliched references to 007 and fearful US Presidents aside, it is hard to create engaging content. Set the Artificial Intelligence language model, ChatGPT, the task of bond market commentary and it comes up with gobbledygook. Try mentioning bonds at your Christmas Party and you will be guaranteed more space at the bar. But the bond market – and in particular the market for UK government debt, better known as Gilts – is central to the outlook for the UK economy. This historically rather dull and predictable market has been anything but recently. Since January 2020, Gilts have been almost twice as volatile as during the preceding two decades – a period that included a Global Financial Crisis. Disorderly Gilt prices helped bring down the Liz Truss-led government, stalks the current Sunak-led government, and strikes fear into the Labour opposition. Every significant public spending decision, pension reform, and upcoming manifesto promise is considered through the lens of how Gilt investors might react. In The Times last week, outgoing Chief Executive of the Debt Management Office, Sir Robert Stheeman – the man responsible for managing UK Gilt issuance for the last twenty years – noted the “challenge” ahead. That is diplomatic understatement from one of the UK’s most impressive public servants of the modern era. The challenge Stheeman identified can be split into at least three separate challenges.

The first and most pressing challenge is to ensure there remains stable demand for new Gilts. Over the last two years the Debt Management Office has sold almost £400bn of Gilts. This pace is unlikely to relent even as the government’s deficit comes down with large quantities of historic debt needing to be refinanced. After fifteen years of very low yields, savers and investors now have more choice as interest rates on cash has moved higher, and dividends from UK shares remain elevated. Gilts have to compete with these alternatives to remain attractive. Every pound needed to tempt Gilt investors is a pound that cannot be spent on public services, or on reducing taxes.   

The second challenge in the Gilt market is to absorb the debt that the Bank of England is now selling – having been a steady buyer for more than a decade. Since 2009 the Bank of England has bought and still holds more than £740bn of Gilts. This was a major part of its Quantitative Easing Programme. But Quantitative Easing has given way to Quantitative Tightening as the Bank sells £100bn a year of these assets back to private investors, pensions funds, and insurance companies. At current prices the Bank of England and, by extension the taxpayer, is making a loss on these sales. Over the last 12 months alone, losses have totalled more than £29bn but – depending on the price investors are prepared to pay for these Gilts – this loss could be dwarfed by a further £220bn of losses over the next decade. This number is highly sensitive to global interest rates. Indeed, in the month since the Office for Budget Responsibility made that estimate a fall in global interest rates will have shrunk that estimate by tens of billions of pounds.    

The third challenge is to judge how much government debt should be long-dated, short-dated, and inflation-linked. This decision has considerable ramifications and comes with much uncertainty. For example, the UK government has historically sold far more inflation-linked debt than its peers – leaving it with a quarter of its debt stock linked to the level of the Retail Price Index (RPI). This looked like a very sensible decision with becalmed inflation, but the outbreak of the COVID-19 pandemic and war in Ukraine has made this punitively expensive as the RPI has skyrocketed. Economists are divided on where UK inflation heads next. Should it unexpectedly crater then more index-linked debt will serve taxpayers well. The inverse is also true.

This challenge is even more acute in the US where current Treasury Secretary Janet Yellen has attracted criticism for her department’s failure to “lock in” low interest rates during the last decade. Readers with 2-year and 5-year mortgages will recognise similar frustration that they didn’t lock in for longer on their own mortgage borrowings. Now with US interest rates still hovering around twenty-year highs the question for the US government is whether to stick or twist with their preference for short duration issuance. A parallel decision in the UK will shape the health of the UK’s public finances for years to come.       

Underpinning all these decisions and judgements is investor appetite to own UK assets – not just Gilts, but company debt and equity. The fear is that international investors who own a quarter of UK government debt and half of UK shares may lose faith in the economic outlook and demand a higher interest rate. Whilst Brexit has tested many aspects of the UK economy, there is scant evidence that it has yet influenced the spread between Gilts and the government debt of other major economies. But the warning signals are already flashing in the equity market where investors are demanding much higher returns to own shares in UK plc. Arguably a similar trend has only been averted in debt markets by funnelling our domestic pensions industry into owning huge quantities of government debt. In doing so this has increasingly denied the private sector the capital it needs to invest and thrive. This creates something of a doom loop where UK productivity and growth is sluggish – necessitating ever more government borrowing.

The hope is that the government, or Labour opposition with its newly announced City Advisory Group, recognise that such an approach with our pensions will end in tears. The challenges presented in the Gilt market are not sustainably resolved by diverting increasing quantities of capital from the private sector to subsidise the government’s bills. They are resolved by making the UK an innovation-led economy that investors want to deploy capital into. Papering over the cracks in the Gilt market using our pension system has gone on for far too long.     

Published: The Times 11/12/2023