Is George Osborne making a fetish of the UK’s AAA credit rating? I ask because what really matters is the cost of government borrowing, which in turn depends upon the market‘s confidence in gilts. However, a AAA rating is neither a necessary nor a sufficient condition for the maintenance of this confidence.
The collapse in the market for credit derivatives shows that AAA ratings aren’t a sufficient condition for the maintenance of market confidence. Nor are they a necessary condition. Spain and Japan have credit ratings of AA, a notch below the UK, but 10 year Spanish government bonds yield just 4.1%, only 0.1 percentage points more than UK gilts, whilst 10 year Japanese government bonds yield only 1.4%.
A top credit rating, then, is no guarantee of continued market confidence, whilst the lack of this rating doesn’t mean confidence will disappear.
There’s a simple reason for this. Credit ratings measure only the risk of default (possible badly). But this is only one of many risks to bonds. And at the higher levels, it is a small risk. S&P, for example, says that an AA rating differs from an AAA one “only to a small degree.”
Instead, bond yields depend upon other risks. One, which hit credit derivatives, is liquidity risk - the danger that you’ll not be able to sell quickly the asset. For government bonds, though, there are two other, bigger, dangers.
One is inflation. In Japan, this is a minimal danger, so investors are happy to buy low-yielding JGBs, despite their second-rank rating.
The other is currency risk. Spanish yields are low because investors believe (rightly or wrongly) that there is only a small danger of Spain leaving the euro and having its currency devalued. With this risk small, yields are tied down by German yields.
Traditionally, these two risks have varied enormously. This is why gilt yields varied so much and were so high in the 1980s and 90s, even though the UK‘s credit rating then was not in question.
Which brings me to my problem. It’s quite possible that, even if the UK keeps its AAA rating, gilt yields could rise if investors perceive an increase in UK inflation or currency risk.
And Osborne’s words seem to add to this risk. In yesterday’s speech, he said he wanted to see “higher exports” - which could easily be taken as code for “lower pound”. And he’s also said that he wants “to keep mortgage rates as low as possible for as long as possible.” But this merely tells the world that he’d like the yield on sterling assets to be low - perhaps at the expense of infringing the Bank of England‘s independence. Which is pretty much an invitation to dump the pound - especially if overseas central banks raise interest rates.
If bond markets see this as a danger, then the benefits to gilt yields from retaining our AAA status could be swamped by a increase in the sterling risk premium investors require for holding gilts.
Now, I’m not saying this will happen. And I’m not saying AAA status is unimportant. I’m just saying that it’s not the be-all and end-all. Other things matter for the government’s borrowing costs. And the Tories aren’t being very careful about these.
The collapse in the market for credit derivatives shows that AAA ratings aren’t a sufficient condition for the maintenance of market confidence. Nor are they a necessary condition. Spain and Japan have credit ratings of AA, a notch below the UK, but 10 year Spanish government bonds yield just 4.1%, only 0.1 percentage points more than UK gilts, whilst 10 year Japanese government bonds yield only 1.4%.
A top credit rating, then, is no guarantee of continued market confidence, whilst the lack of this rating doesn’t mean confidence will disappear.
There’s a simple reason for this. Credit ratings measure only the risk of default (possible badly). But this is only one of many risks to bonds. And at the higher levels, it is a small risk. S&P, for example, says that an AA rating differs from an AAA one “only to a small degree.”
Instead, bond yields depend upon other risks. One, which hit credit derivatives, is liquidity risk - the danger that you’ll not be able to sell quickly the asset. For government bonds, though, there are two other, bigger, dangers.
One is inflation. In Japan, this is a minimal danger, so investors are happy to buy low-yielding JGBs, despite their second-rank rating.
The other is currency risk. Spanish yields are low because investors believe (rightly or wrongly) that there is only a small danger of Spain leaving the euro and having its currency devalued. With this risk small, yields are tied down by German yields.
Traditionally, these two risks have varied enormously. This is why gilt yields varied so much and were so high in the 1980s and 90s, even though the UK‘s credit rating then was not in question.
Which brings me to my problem. It’s quite possible that, even if the UK keeps its AAA rating, gilt yields could rise if investors perceive an increase in UK inflation or currency risk.
And Osborne’s words seem to add to this risk. In yesterday’s speech, he said he wanted to see “higher exports” - which could easily be taken as code for “lower pound”. And he’s also said that he wants “to keep mortgage rates as low as possible for as long as possible.” But this merely tells the world that he’d like the yield on sterling assets to be low - perhaps at the expense of infringing the Bank of England‘s independence. Which is pretty much an invitation to dump the pound - especially if overseas central banks raise interest rates.
If bond markets see this as a danger, then the benefits to gilt yields from retaining our AAA status could be swamped by a increase in the sterling risk premium investors require for holding gilts.
Now, I’m not saying this will happen. And I’m not saying AAA status is unimportant. I’m just saying that it’s not the be-all and end-all. Other things matter for the government’s borrowing costs. And the Tories aren’t being very careful about these.
I'm not comfortable leaping to the defence of a Conservative shadow chancellor, but after your string of posts, I will! At least recognize Mr Osborne is giving some thought to the economic mess we are in.
I fully accept your argument about currency risk and inflation and their potential impact on gilt yields. The 1970s showed what can happen if you lose control of inflation. But I would give Mr Osborne a bit of credit for alluding to three other historical lessons. Two of these were in the UK and followed economic crises (Thatcher-Howe fiscal squeeze in 1981, Major-Clarke squeeze in 1992-93). You might say policymakers were 'lucky' in both cases, but they show how a fiscal squeeze, looser monetary policy and a lower exchange rate can rebalance an economy quite effectively. The third example is the Clinton-Greenspan pact of the early 1990s, where - allegedly - Mr G promised looser monetary policy if Mr C tightened fiscal policy.
Of course, economic conditions are somewhat different right now, which is why I suspect the Tories are backtracking on some of the promised spending cuts, at least initially. But, as far as I know, the current government has offered no convincing explanation of how we get out of this mess. And the electorate is in denial about just how much their living standards are going to get hit in coming years.
Posted by: Econoclast | February 03, 2010 at 01:16 PM
umm, but "if what really matters is the cost of government borrowing", we're talking about the real cost not the nominal cost, aren't we? So even if inflation causes nominal yields to rise, is it right to say it's increasing the cost of servicing debts?
not sure about exchange rates .... if investors are expecting depreciation they'll want higher yields, but once depreciation has happened, what then? What I mean is, how large is the overall increase in the cost of borrowing, over time? If we'd depreciated, might investors be even more willing to lend, with exports up and imports down? just thinking aloud
Posted by: Luis Enrique | February 03, 2010 at 02:55 PM
FWIW there is a very close relationship (until last few weeks) over past year or os for the 10 yr gilt yield and the euro/sterling exchange rate - its the lower the gilt yield the weaker sterling, and vice-versa (the exchange rate has been inversed). See
http://www.flickr.com/photos/mjtphotos/4327539387/sizes/o/
Why would this be? Flight-to-safety hurts sterling but benefits gilts? The lower sterling goes the more likely it is to go higher, so benefits gilts?
Posted by: Matthew | February 03, 2010 at 04:56 PM
Terribly important politically, no? The government that presides over the UK (or US) losing its AAA rating will be a poor discredited thing, not long for the world.
David Smith, viewsflow.com
Posted by: Dhsmith24 | February 04, 2010 at 03:22 AM
Are you saying the Tories are inviting "Labour's Sterling Crisis" headlines?
Maybe.
Posted by: Guido Fawkes | February 04, 2010 at 02:44 PM
More like desperately, cocaineically hopping about flapping their arms and shouting "sterling crisis!" while more quietly saying their own policy is "monetary activism".
Meanwhile, can we all stop caring about sovereign CDS prices? Does anyone believe that a) any of the people writing sovereign CDS would be able to pay out in a UK default scenario, b) that any of the people buying it would be able to collect, c) that a eurozone sovereign crisis wouldn't be resolved on terms designed to avoid a formal event of default, e) that the buyers aren't either buying it because it's dirt cheap and it lets them tick a box, or else just 'cos it's going up, and f) that the sellers aren't just playing Capital Decimation Partners?
Posted by: Alex | February 04, 2010 at 05:40 PM
It seems to me if anyone really believed sovereign CDSs would be useful in event of a default the Treasury could simply stick one onto each gilt it issues.
Posted by: Matthew | February 05, 2010 at 11:02 AM