Bank bailout may weaken British government bonds


Gilts Market May Be Hit by Bank Bailout

By Ambrose Evans-Pritchard
The Telegraph, London
Tuesday, April 22, 2008

Goldman Sachs has advised clients to take out "short" positions on British 30-year Gilts before a rash of new issues by the Government floods the bond market.

The closely watched US investment bank said it was concerned about the "heavy supply of longer-dated paper" likely to weigh on the price of British sovereign debt.

The bank has closed its "short" positions on the pound after raking in bumper profits on the precipitous slide in sterling since the Northern Rock debacle.

Goldman's quiet move adds to worries that foreign investors may begin to shun British bonds as Prime Minister Gordon Brown pushes through a liquidity deal to kick-start the lending system.

Yields on the benchmark 10-year Gilt surged from 4.43 percent to 4.71 percent last week, one of the sharpest moves in recent years. They are now 67 basis points above German Bunds and 88 basis points above US Treasuries.

It is hard to untangle how much of this jump stems from renewed inflation fears, and how much from concerns that the British state may be taking on massive liabilities from the crumbling housing market.

The UK already has the worst fiscal profile of any major country in Europe or North America, with a budget deficit topping 3pc of GDP at the peak of the cycle.

Marc Ostwald, a bond expert at Insinger de Beaufort, said Gilt issuance was set rise to L72 billion this year from L58.4 billion in 2007, even before the decision to let the Bank of England to swap mortgage collateral for AAA Gilts.

Mr Ostwald said: "British finances are in a parlous state. It is more than likely that the deficit will reach 4 or 5 percent of GDP, and it could be far worse if things go pear-shaped. What is shocking is how fast the picture is deteriorating. Our overall debt could reach levels above 60 percent of GDP."

The Bank's three-year swap arrangement will almost certainly see a flood of new Gilt issues.

The Bank has just L3 billion on its books, tiny compared to the Federal Reserve's $800 billion (L404 billion).

The Treasury will have to step in with new issues. The Debt Management Office has already announced plans to add L15 billion to the Gilt stock, prompting talk it is preparing for the lifeboat operation.

The banks have roughly L35 billion of mortgage securities frozen on their books, says Lehman Brothers and these are likely to swapped for Gilts.

Goldman is offsetting its bet against Gilts with a "long" position on one-year money market rates, known as Sonia (Sterling Overnight Interbank Rate).

The assumption is that the Government's plan will cut Sonia spreads from their current stratospheric levels.

"Gilt bears" say UK bonds will lose some of the safe-haven appeal they have enjoyed since the credit crunch began.

As the panic subsides, the underlying realities of the British budget may draw closer scrutiny.

Capital Economics has warned a hard landing for the economy could have a "catastrophic impact" on UK public accounts. "A recession as deep as the early 1990s could push borrowing up to L150 billion per annum," it said.

This dire scenario is less likely now under the Treasury rescue. Even so, there are rising risks. The bond vigilantes who hold UK debt are not captive British pension funds.

Foreigners own L166 billion of Gilts, making Britain vulnerable to a sudden loss in confidence. The Northern Rock bailout has already added L100 billion to the UK national debt, at least in nominal terms.

It is unclear how much of this will be recovered if house prices fall by 15 percent, as Citigroup now predicts.

At some point, the ever bolder efforts of the British Government to shield the mortgage industry from the consequences of its own errors will exact a toll on the nation's credit rating.

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