The UK economy: new growth figures, public finances and the gilt market

This morning sees the publication of the second estimate of 1st quarter growth in 2010 for the UK and is likely to see a small increase on the previously reported 0.2%. In case anybody is wondering how this happens I would remind you that the first estimate only includes approximately 40% of the data. So today more data will be added and other economic figures published since the first estimate have in general been slightly stronger than it implied. Also since I last looked at the UK in detail we have had two developments in some new (improved) figures on the UK public finances and some detail on the planned £6 billion of public-sector cuts that the new Liberal-Conservative coalition government plans to make.

UK Public Finances

These have been something of a curates egg for me. This is not that the figures have been bad but that I was expecting the annual fiscal deficit to be around the £178 billion forecast and yet as we came to the end of the 2009/10 fiscal year suddenly the figures improved. Then on Friday we had some revisions to the figures which improved them again. Now this is of course good news but is very much against the trend of previous recessions I have studied when a period like we have just gone through usually has led to our public sector finances being worse than forecast rather than better than forecast. Perhaps the UK Treasury really put the kitchen sink in the figures this year and fooled me! More seriously I suspect that perhaps they were afraid of further intervention in the banking system being required and left some leeway for this. Back in the darker days of early/mid 2009 this is quite plausible.

The Numbers

In April 2010 the UK Public Sector Net Borrowing Requirement (PSNBR) was £9.96 billion in April. Just to continue the better than expected trend of these figures it was less than the £11.0 billion consensus expectation of City economists and only up by £1.16 billion on the figures for April 2009 when it was £8.8 billion .Although the good news needs to be tempered by the fact that it was nevertheless the highest April PSNBR ever recorded.

There was also a revision to the numbers for the fiscal year 2009/10. On the definition the UK Treasury uses the figures were revised down by £7.5 billion to £156 billion. Now if we look at international comparisons the UK’s position is considerably improved from the darker days when we thought we might end up borrowing more as a proportion of our economy’s output than Greece. This out-turn at 11.1% of Gross Domestic Product is a lot better than Greece’s which was last estimated at 13.6%,and after writing about Spain yesterday we have just nudged under her figures too.

What has caused the improvement?

Several factors are at play here specifically.

1.Tax revenues have improved in response to the economy’s return to growth in the fourth quarter of 2009. Factors here have been the rate of VAT rising back up to 15.0% to 17.5% in January for example and there have been recent higher bonus payments leading to more income tax being raised

2. Unemployment has continued on a lower trend than was expected leading to a lower level of government spending on such things as welfare benefits. For example there has been a  decline of 110,900 in claimant count unemployment from last October’s 12-year high of 1.63 million.


We should all smile at these figures as they are better than expected and are something of a small relief. To my mind it is the fact that unemployment has risen much more slowly than expected which has been a powerful influence on these figures and we should be grateful for that too. However the figures in terms of scale are still bad just not quite as bad as they might have been. So we need to progress on with plans for reducing our deficit as I still believe that it is possible that the attention of the financial markets will turn to us and it is better to avoid that if we can.

I wrote on the 25th April about my concerns for this year and that the public-sector finances could prove problematical. The reasons for this were.

a. Our economic growth forecasts are very optimistic. 

b. Our unemployment forecasts are also rather optimistic going forward particularly as I have highlighted above there needs to be cuts in the public-sector. 

c. Tax changes may have shifted revenue into the year just gone and out of the year to come. 

d. Under the self-assessment system taxpayers now have the opportunity to update their future tax payments based on last year which overall was a poor one for the economy.

But at least we are starting from a better than expected position.

Yesterday’s Public-sector cuts

Today will see the Queen’s speech where the new government sets out its legislative objectives in detail but the Chancellor got in his plans for a £5.75 billion cut in the public-sector a day early. There are in fact £6.25 billion of cuts but £500 million extra is going to be spent on apprenticeships and youth unemployment. One example of the cuts is the end of Child Trust Funds to which will be added a civil service recruitment freeze and the scrapping of some Quangos. So we have some detail and the numbers appear to add up but the truth is we will get the real much bigger news on June 22nd when the Chancellor unveils his budget.

The UK government bond market (UK gilts)

This has been a rather curious market this year. If you looked at it in isolation you would conclude that with such a high fiscal deficit and therefore a lot of likely gilt issuance and the fact that we appear to be returning to economic growth with some inflation present you might well feel that UK gilt prices should be falling and yields rising. Indeed for a period this year they did. However more recently they have dropped and if you look at todays falls in stock markets as I type this one might expect them to rally more.

So rather than the feared apocalypse we have got a rally just as you might expect the gilt market to be under pressure. I think that there are several causes of this.

1. There has been a flight to quality in international markets and the UK is perceived as a safe country in this regard. It might be hard to believe when you look at our fiscal deficit but another country in a similar situation the United States has seen its bond yields benefit from this too.

2. The fall in the value of the sterling exchange rate has made gilts more attractive to foreign buyers. In a sense our 25% depreciation since late 2007 has made gilts look cheaper in their domestic currency and of course it is in that currency they purchase.

3. Because of the Bank of England’s programme of Quantitative Easing many natural buyers of gilts such as insurance companies, who use them to hedge their annuity business for example, may have been crowded out of the market and can now return. Just to give you an idea of scale we bought some £200 billion of our own debt which was slightly more than one years issuance.

4. Very low short-term interest rates may have persuaded investors to invest in medium/long-term gilts which offer a much better yield.

5. Those who feel that we will see a double-dip in our economy and further recession will have been happy to buy gilts and wait for the interest payments and potential capital gain.

The effect has been that our ten-year government bond yield is now 3.5%.

Some curious corollaries of this

This situation has two oddities to my mind. The first is that if you compare our conventional gilt yields with inflation. Our Consumer Price Index reads 3.7% and our old measure RPI-X reads 5.4%. Should they stay where they are then if you look at the yields on our gilts you have to go as far as March 2022 before any of them yields as much as CPI so in real terms you would be expecting to make a loss. If you use the old target them I am afraid that you cannot buy a conventional gilt of any term to offer you a yield to cover this.

Now you might say you expect inflation to fall. The Bank of England seems to be overshooting its target these days so let us assume inflation of 2.5% going forwards. Every conventional gilt maturing in the next five years yield less than this so again in real terms you would be expecting to make a loss. Curious is it not?

Another factor is that as equity markets fall and gilts rally then we are again at a level where the expected dividends from the equity market exceed the coupons from gilts. This is a measure which in normal times would make investors switch from gilts into equities. And there is the rub we are plainly in nothing like normal times.


The time horizon of gilt market investors is in my view very short currently and they are not thinking of the long-term consequences of their holdings. Buying UK ten-year gilts at 3.5% yield at this time would lead any computer programme you had written to analyse the gilt market to blow up! This is because these yields would not compute with the level of issuance required and our level of inflation both present and expected.

There is another more apocalyptic view and that is that we are about to go into a double-dip recession which may persist and you take any yield that you can. It is not my view but so far this year it has been working.

I am left with the thought that it is the two factors I have written about so much recently that have led to this situation. Fear and uncertainty. These make for strange bedfellows in the investment world and to my mind the UK gilt market is currently a strange bedfellow.

UK Growth

Whilst I have been typing todays update I see that UK growth has been revised upwards to +0.3% for the 1st quarter of 2010. So good news as industrial production in particular improved. In what is looking an increasingly difficult year we should be grateful for every scrap of growth.


I see that world equity markets are falling heavily. I wrote on this subject on the 21st of May . Also as the days have gone by we have seen inter-bank markets become more fractious and disturbed. This is significant beacuse this is something we saw in the run-up to the Lehman crisis. Now this dislocation is nothing like what we saw then yet but yesterday we saw three month dollar offered rates (LIBOR) go above 1/2% and are now 0.51%. Also some banks are being made to pay more than this. This is a problem ticking away in the background that issues such as Cajasur (and its implications) which I discussed yesterday will only make worse.

On a separate note it is being reported that today’s falls are due to a build up of troops on the North Korean border at the end of last week. It is the end of last week bit that bothers me as it is not much of an early warning system is it?

One rather symbolic move I have seen on Reuters this morning concerns Germany. Her ten-year bond yields have fallen to 2.59% and her bund future has risen to 129.28 both records. If you wished to define an instrument which might benefit from fear,uncertainty and flight to quality German bunds fit the bill. Put another way it seems fear,uncertainty and flights to quality are dominating things right now.


3 thoughts on “The UK economy: new growth figures, public finances and the gilt market

  1. Hi Shaun “The time horizon of gilt market investors is in my view very short currently and they are not thinking of the long-term consequences of their holdings.” I think you are correct there. The situation, as you have observed, just does not add up. Normal constraints and stimuli do not seem to be at work in the current Gilt market.

    “…yesterday we saw three month dollar offered rates (LIBOR) go above 1/2% and are now 0.51%. Also some banks are being made to pay more than this. This is a problem ticking away in the background that issues such as Cajasur (and its implications) which I discussed yesterday will only make worse.” Absolutely, as I posted yesterday this is perhaps a sign of things about to precipitate?

    All in all, many puzzling features here methinks?

  2. my only assumption is that gilt investors think we are heading for a bout of delfation due to the cuts agenda, we wont be printing any more money vi QE and we have a strong government who will sort out fiscal position out over the medium term. I would guess they also believe Sterling is unlikely to devalue much further and possibly will reound significantly once the emergency budget kicks in to stimulate the private sector recovery.

    All of which puts us in a pretty good position.

    Bizarre to think relatively our standing in the world is improving even as our personal situations potentially worsen with cuts and taxes.

  3. People are worried that the euro is going to implode, and possibly implode quickly if one State pulls out suddenly. This is unlikely but, critically, not impossible. One doesn’t know where the next horror story is coming from in the eurozone. Spain? Italy? Portugal? What new and bizarre stunt will the Germans pull next? Investors are looking for a return OF investment rather than a return ON investment and low yields on British bonds are the least of their worries. Sterling at least has the excellent advantage of probable continued existence a year from now irrespective of its value versus the dollar or gold etc. Near-guaranteed existence combined with some kind of yield – what’s not to like?

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