Will markets put the Vulcan Nerve Pinch on Darling?
Some thoughts on the UK budget...
1. This is a multi-layered story where the econo-wonk press gets the biggest issue - which is fiscal credibility - and the politico-press is going, quite understandably, for the more easily "relevant" story of labour's U-turn on the higher 50% tax rate. (We'll be doing both tonight on Newsnight).
2. There is a slight but serious chance that the bond markets will go on strike and not buy the UK's £220bn debt. A lot of bond traders are going on the airwaves to say they probably will buy it, albeit at a higher interest rate. But bond traders are Spock-like beings who play 3D chess at one-move-a-day-pace. The ones not talking to the press are the ones thinking about putting the Vulcan Nerve Pinch on Darling.
3. A quick explanation of gilts: gilts are IOUs issued by the government over periods of 5, 10, 30, and 50 years and bring a guaranteed interest payment for the buyer, paid every six months. Two thirds are held by pension funds, as they supply a ready and predictable source of income. Once issued gilts can be traded, so their price can go up or down compared to the interest rate guaranteed. Out of this relationship you get a yield - which is a bit like a "real" interest rate. If the price of gilts goes down, because there's not enough demand, the yield goes up - and the government effectively ends up paying a higher interest rate on its debt. (Pile in ye pedants and diss me on the detail, but I think this is the best simple explanation I can give).(Guido also onto this story gives a useful graph of the forward price of gilts).
4. OK so if the markets don't believe the government's 3.5% growth prediction for 2011 they will start pushing the yield upwards (and the price downwards). The yield on a 10 year Treasury Gilt (here) is currently 3.45% (you can see it each day at the bottom of the front page of the FT's companies and markets page).
5. The aim of the government's quantitative easing strategy is to get the yield down. The Bank of England is buying up gilts to push yields down. But the fears over the UK budget deficit will push yields up. They have already started to creep up in response to the credibility fears we covered on Newsnight last night. Gillian Tett interesting on default risk in general.
6. So, yes, you have worked it out right: the lack of credibility on economic forecasting and debt is working directly opposite to the £150bn being printed by the Bank of England to do quantitative easing.
7. How will it end? Well what the bond markets typically fear is two things a) a default, where Britain refuses to pay its debt. This right now is a theoretical impossibility. And b) inflation - where the government allows inflation to inflate away all that interest over the 10,20 or 50 year life of the bond, leaving the bondholder as sad as a 1923 German with his wheelbarrow full of worthless notes.
8. This article explains more about the fears in the bond market right now. But the canny traders are looking ahead to the November PBR. If there is no election before then, and he does not get reshuffled, Alistair Darling will have to stand up and say whether the 3.5% prediction is right. Indeed since he predicted growth to begin in Q3 2009 he will have a good idea whether he's going to be proved right or wrong. If we are then faced with a further upward revision of debt, a further downward revision of growth, then he hole in the finances will look bigger and the tax take will have to increase even further. Senior Tories believe this will have to be done by raising VAT, as the government was caught discussing in a recent leak.
9. We will know by November whether yesterday's figures were over-optimistic. Sometime between now and then the debt rating agencies will have a look at the UK's public finances and decide whether it keeps its AAA (zero chance of default) rating. See here for why they are already considering a downgrade.
10. Finally the Institute for Fiscal Studies has just said that total government spending will be cut by 0.1% a year in real terms, between 2011-2014, the lowest three-year spending growth for any government since 1996-1999.