In the group’s Global Outlook for the fourth quarter, government bonds investment director Laing pointed out that gilts, along with other perceived safe-haven sovereign bonds, have been supported by weaker-than-expected economic data in the year so far.
“Safety premia have never been so expensive for gilts, as overseas investors looked relatively favourably on the UK’s more coherent fiscal plans and accommodative central bank policy,” he wrote.
But Laing, who co-manages the Standard Life TM UK Government Bond Fund, warned that these supportive factors could be at risk.
Any change to government policy which deviates from the current austerity package would place the UK’s AAA credit rating at risk and threaten gilt prices, Laing said. The consequences of an isolated downgrade would probably be mild, he claimed, although the effects would be more severe if the market expected further downgrades to follow.
The coalition has been under constant pressure to ease of austerity, as groups such as the International Monetary Fund argue that austerity measures are not working in many countries and recommend a slower pace in the struggle against high public debt.
In addition, the Office for Budget Responsibility, the government’s independent economic forecasting body, today said spending cuts and tax increases may have damaged economic growth more than it originally assumed – adding to weight to arguments for a tempering of austerity.
Laing also noted that the Bank of England’s future monetary policy will play an important effect in determining market direction. Current gilt valuations are warranted so long as the bond purchase programme continues and net supply remains close to zero.
But any move away from QE and towards other measures that undermine the current favourable supply/demand balance in the gilt market – such as greater use of schemes like the Funding for Lending plan – would lead to a “sell off” and hit valuations, he claimed.
Last week, FSA chairman Adair Turner, a leading contender for the next governor of the Bank of England, said QE could demonstrate “declining marginal impact” and argued for UK monetary policy to “employ still more innovative and unconventional policies”.
With growing concern that further rounds of QE will create diminishing benefit to the economy and an increased willingness to employ schemes such as Funding for Lending to stimulate bank lending, the exact instruments the Bank may choose to use are far from certain.
Laing concluded: “As long as uncertainties about the eurozone persist, and the Bank is buying up gilts faster than the Debt Management Office are issuing, we cannot be short of the gilt market. However, we are concerned that continued fiscal slippage could see gilts lose some of their recent attraction.”