Economy struggles as double dip concerns send gilt yields to an all-time low
Yields on 10-year gilts dropped to record lows yesterday as capital markets threw their weight behind gloomy predictions for the British economy and the expectation of very low interest rates for the foreseeable future.
Government bond yields fell by almost 10 basis points to an intraday low of 2.839 per cent following comments from Martin Weale, a newly appointed member of the Bank of England's Monetary Policy Committee, casting doubt on the Bank's growth forecasts for 2010 and warning of a "significant" risk of a double-dip recession.
Mr Weale's remarks – which downplay fears of rising inflation, and therefore suggest that interest rates will remain at current unprecedented lows for longer than assumed – helped to push yields down to close at 2.884 per cent, the lowest level on record.
Yields on 10-year gilts hit a 16-month high in February, at the height of concerns about rising inflation, spiralling public debt and the risk of a credit rating downgrade. But they have fallen consistently since the election, as fears of a sovereign default receded, in part thanks to the Coalition Government's emergency Budget committing to eliminate the current structural deficit by the end of this Parliament.
Perversely, concerns that such tough spending cuts will put a drag on Britain's economic recovery are themselves helping to cut government borrowing costs by boosting gilt prices and cutting yields. "The simplest explanation of the drop in gilt yields is a dramatic reassessment of the likely path of interest rates, and the resurgence of the view that they are not going up any time soon," John Higgins, the senior markets economist at Capital Economics, said. "The UK's strong economic growth in the second quarter is not indicative of what is to come: the fiscal squeeze is yet to bite and will then bear down heavily on economic activity, which will mean monetary policy will need to stay very loose."
The slide in yields also suggests that capital markets do not agree with recent predictions from the Policy Exchange that interest rates could be set to rise as high as 8 per cent. The think-tank's chief economist, Andrew Lilico, argued last weekend that more quantitative easing to fend off a double dip will turn into rampant inflation once the economy returns to growth, with high interest rates needed to tame it.
The drop in yields has already been huge – from more than 4 per cent as recently as April. But the fall is not only a response to Britain's domestic situation. Gloomy economic data in the US has dragged down Treasury bond yields, opening up international arbitrage opportunities that swiftly reverberate through to both British and German bonds.
Stephen Lewis, the chief economist at Monument Securities, estimates that less than half of the fall in yields can be attributed to domestic factors. And with further falls yesterday on National Association of Realtors data showing a disastrous 27 per cent fall in home sales in July – the biggest monthly drop ever – the trend is not expected to reverse.
"The international forces will continue to be strong," Mr Lewis said. "We will not break away from trends in the US and we can expect more weak data over the coming months."
The only countering influence could come with the Coalition Government spending review in October. "There could be a growing appreciation of the difficulties of cutting the deficit as we get to the detailed Spending Review," Mr Lewis said. "That could be an off-setting factor, but over the next month or two yields will continue to fall."
The gloomy economic outlook reflected in the gilts market was further underlined yesterday by the latest subdued data on bank lending published by the British Bankers' Association (BBA). Following a slew of reports of a dip in the housing market in recent weeks, the BBA said the number of mortgage approvals slid by nearly 1,000 to 33,698 in July. Although annual growth in net lending came in 4.1 per cent higher than in July 2009, net lending of £2bn remains slightly below the average over the last six months. And against the rule of thumb that the market needs around 80,000 approvals each month for gradually rising house prices, performance is still weak.
Malcolm Barr at JPMorgan Chase said: "July appears to be another month in which housing turnover has remained very low with hints of a mild downtrend."