By Kevin Adams, director UK fixed income at Credit Suisse The period from May to September saw a...
By Kevin Adams, director UK fixed income at Credit Suisse
The period from May to September saw a significant rally by bonds in the UK and overseas.
Interest rate expectations that had been focused on rising rates before year-end reversed amid signs of slowing growth and carnage in the equity markets.
Interest rate futures markets began to price in the prospect of additional rate reductions and two-year gilt yields fell briefly below 3.5%, as cash from the equity market was placed in the ultimate risk-free asset of short dated government bonds.
The rally in equities during early October saw bond markets give back some of the gains from the six month long bull phase but yields are still towards the low end of recent historical ranges.
The UK economy continues to exhibit its two-speed tendencies ' manufacturing industry stalled and the personal sector moving ahead, although the consumer does appear to have changed down a gear over the last few months.
The housing market, meanwhile, continues its structural adjustment to permanently low mortgage rates or its bubble inflation according to your point of view. House prices aside, the general perception that the UK economy is slowing a little should be good for gilts.
Analysts are increasingly focusing on the Government's tax revenue and spending numbers. The Budget this year forecasts growth of 2% to 2.5% in 2002 and 3% to 3.5% in 2003. Both of these estimates are likely to be too high.
The first estimate of GDP growth for the year to September recorded a 1.7% increase and growth in the final quarter of this year will have to be 0.5% or better in order to achieve the bottom end of the Treasury estimate for 2002 as a whole.
This looks to be demanding and if consumer activity tails off a little more and the industry remains sluggish, the 3% to 3.5% target for 2003 looks rather over optimistic. Slower than expected growth will lead to lower tax revenues.
Meanwhile, government spending is increasing apace as the improvement in public services moves ahead. According to Barclays Capital, departmental spending in September was 11.2% higher than a year earlier. Public sector finances are therefore deteriorating with the 12 months Public Sector Net Cash Requirement (PSNCR) moving from a surplus of approaching £20bn in late 2000 to a deficit of £11bn. This excludes the additional windfall from the 3G telecoms licence receipts in 2000.
Respected commentators are now suggesting that the PSNCR will overshoot government expectations by £5bn-£7bn this year and by maybe as much as £20bn in the medium term.
If this happens, the chancellor has two choices ' raise taxes or borrow more. Although the next general election is some years away, it seems unlikely that the Government will further increase the tax burden that is already on the way up next year with higher National Insurance contributions.
More likely is a fudging of the chancellor's self-imposed golden rule for the nation's finances resulting in greater borrowing and therefore more gilts for sale.
Low inflation environment.
Low interest rates.
Continued demand for UK bonds.
Increasing supply of government bonds.
Poor valuations relative to equities.
MArket anticipates low growth/inflation.
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