Debt threat to gilts

I’m not being contrarian. The fact is that the best times for gilt investors are when government borrowing is high. The big deficits of the early 1990s, 2008-09 and last year saw better returns on gilts than did the public sector surpluses of 1999-2000.

There is, of course, a simple reason for this. Government borrowing is the counterpart to private sector net lending. When the private sector invests less and saves more we get a recession – and recessions are good for government bonds. But the counterpart to increased private sector net lending is, by definition, increased government borrowing.

In 2020 government borrowing rose  from 2.4 per cent of GDP to 12.4 per cent. The biggest counterpart to that was increased net lending by households, which jumped from one per cent of GDP to 8.3 per cent, largely because lockdowns forced most of us to save much more: household  savings rose from 6.5 per cent of disposable income in 2019 to a record 15.8 per cent last year.

Which brings us to the danger for gilts. As the lockdown lifts and pubs, restaurants and “non-essential” retailers reopen we’ll see a consumer boom as households release their pent-up savings. Even if this is not terribly inflationary it might well trigger a further sell-off of gilts simply because a stronger economy reduces demand for safe assets. Yes, everybody is expecting a strong recovery, but it does not follow that this is priced in, because investors might not be fully anticipating the impact the recovery will have upon their taste for risk.

But the very same fall in households’ net lending that causes the consumer boom will also cause government borrowing to fall. Which means we might well see gilts sell off as the public finances “improve”.

As you might imagine, though, things aren’t quite so simple. While households’ net lending will fall, the corporate sector’s won’t so much simply because it didn’t rise much last year. The ONS estimates that their  gap between retained profits and capital spending increased only from minus 0.5 per cent of GDP in 2019 to 0.1 per cent last year. This is because while some firms have seen their cashflow improve – partly by putting capital spending plans on ice – others have had to borrow to see themselves through the pandemic. For many, their response to the post-lockdown recovery in demand will be to pay down debt.

Their reluctance to hire and expand will prevent the post-lockdown boom from feeding on itself. This will tend to depress tax revenues, thus maintaining government borrowing: by brute accounting identity, a corporate financial surplus must mean a deficit somewhere else. But it will also cause doubts about the pace of expansion which will support demand for gilts.

Nobody knows exactly how these competing forces will play out: we have no precedent to help us.

But we do know something. Government borrowing is irrelevant for investors, at least in nations that can print their own money. It is the outcome of millions of private sector decisions about how much to spend and save. And if these decisions do cause government borrowing to fall sharply, they will very likely also cause gilt yields to rise.