Get used to it as the UK will be bounced from that ever-shrinking ,exclusive club of triple-A nations before very long. The UK’s public sector finances were already a train wreck before the Great Crash II began in earnest in 2008. No matter how much tape and plaster UK Chancellor George Osborne applies at next month’s Budget, it is only a matter of time before the ratings agencies deliver the coup de grace. Britain’s cherished AAA status will be a thing of the past and it could stay that way for a long time.
January’s bumper £11bn surplus did little to mask the dire state of the nation’s public sector finances. UK fiscal attrition is supposed to be restoring better repair to the country’s finances, but the consequence is putting UK recovery prospects back on the road to ruin. Double dip UK recession already seems to have turned into triple trip downturn, judging by the 0.3% fourth quarter drop in output. The deficit is already running 1.6% higher than where it stood a year ago. The downturn is wrecking revenue returns. The 7% of GDP deficit target set for this year is set to be breached. This is not the only anathema for the ratings agencies. It is the longer lasting damage that government austerity poses for growth prospects that is unsettling Moody’s, S&P and Fitch. Going forwards without sustainable growth it will be even harder for the UK to drag itself out of the fiscal mire. The UK seems set on a self-sustaining downward spiral. Japan has been stuck in this rut for the last decade.
Does a downgrade matter to the UK? Apart from the obvious knock to national pride, the damage is probably more cosmetic than collateral. Japan lost its Triple-A status as far back as 1998, and other cuts followed. Yet Japan’s bond market remains functioning and rates and yields are ultra low. And the yen maintains reserve currency status despite massively worse fiscal fundamentals than the UK. A drop from triple-A status may mean some extra upward pressure on UK gilt yields, but nothing too dramatic. Demand for UK government debt remains pretty strong. The bond market still remains in the grip of a 30-year mega bull run and the positive fundamentals still remain intact. Thirty-year UK gilt yields have only just pierced the 3% threshold and remain significantly below the 12% yields knocked up at the height of the UK ERM crisis in the early 1990s.
Of course low UK bond yields are a major by-product of the Bank of England’s quantitative easing policies, as gilts have been snapped up in the central bank’s bond-buying spree. They now own over a quarter of the UK gilt market. The BOE are hardly likely to blanche at a UK rating cuts. While the QE programme remains in place, they remain firmly locked into gilts for the duration. That is unlikely to change for a long while judging by the BOE’s latest policy missives. The BOE’s continuing support for gilts looks ironclad.
Overseas investors do not seem too dismayed either. UK government debt remains a great safe haven diversification bet from Eurozone event risk. And the recent plunge in the pound makes UK debt even cheaper on a relative value basis for global bond investors looking for currency plays.
Domestic institutional demand remains a strong force as ever. It is not just positive economic fundamentals – low growth, low inflation, and low interest rates. But it is also because UK institutional demand for gilts, especially for longer dated maturities, remains strong for balance sheet management purposes. UK pension funds and life assurance companies have a natural appetite for longer term gilts to match off longer term liabilities (policy commitments). Super long gilts tend to get swept up and put in the bottom drawer for maturation. A debt downgrade would have little impact on this structural appetite.
Of course, Osborne could always change tack and throw caution to the wind and go for growth blowing his deficit targets out of the water. It is probably too late for that now as he is more likely to be damned either way in the ratings agencies eyes. They seem to scent blood and a feeding frenzy must ensue. In any case, this Chancellor is unlikely to change his spots.
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