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Beware gilt market complacency after UK sovereign downgrade

Non-resident demand for UK gilts is likely to be dampened by elevated credit and FX risk at a time of relatively high supply, Nomura analysts conclude.

For an apt illustration of how asset markets have taken sovereign downgrades in their stride, look no further than the market reaction on Monday, after Moody’s, over the weekend, removed the UK sovereign’s triple-A rated halo. Growth-sensitive assets, namely European equities, and the gilt market comfortably digested the news, with the 10-year yields rising just four basis points to 2.15%, while the sterling traded at a 16-month low.

The relatively sanguine market reaction bears a resemblance to November last year when Moody’s became the second ratings agency to strip France of its triple-A rating. The move – shoving the sovereign out of banks’ benchmark top-grade bond indices – subsequently triggered a similarly modest 8bp increase in French 10-year yields to 2.15%.

Such a reaction underscores how bond investors had largely priced in the declining sovereign creditworthiness of the UK and France, while reflecting the positive technicals of the market, amid a global collateral crunch and the structural decline of triple-A rated assets, with Canada and Germany one of the few sovereigns remaining in the prized club.

What’s more, the largely nonchalant reaction – along with the perverse flight-to-safety bid for US Treasuries amid the 2010 downgrade – has fed optimism from UK government officials that the gilts market has already priced in the downgrade.

Even though non-residents own roughly one-third of the gilt stock, the ratings action has been seen in the context of the UK’s negative intra-weekly newsflow, rather than constituting an event risk, conclude Nomura analysts.

The market upshot appears to be: ratings are a greater driver of corporate bond investments because sovereigns are more uniform, making cross-country comparisons, based on transparent macroeconomic data, easier for analysts and investors, which all means sovereign ratings actions don’t come as much of a surprise.

What’s more, the correlation between sovereign ratings and yields is weaker than that of corporates, thanks to market technicals – such as owning a domestic central bank, regulations and bank-demand for sovereign debt – as well as the principle of sovereign immunity.

Demand-supply equation

However, in a report published on Monday, Nomura fixed income analysts warned that the downgrade could prove more bearish than the gilts investors are predicting.

“We are deeply wary of analysis, based on the example of France and the US, that a downgrade is a ‘sell the rumour, buy the fact’ event, as there were specific circumstances in place at these times in these countries which are not relevant now,” they stated. “We retain, and add conviction to, our bearish gilt bias, best expressed on a relative basis against Bunds.”

The bond market largely digested the impact of the US and French downgrade because the respective rating actions took place before liquidity-positive developments, principally ECB and US Fed support.

By contrast, Nomura analysts warn that Moody’s downgrade could be negative on both the supply and demand equation for UK government bonds. They predict that, despite Osborne’s protestations to the contrary, the government is likely to ease up its fiscal tightening agenda, boosting gilt supply that will be met with weakening demand.

On the demand side, they add: “Yes, an AAA loss is not an out-of-the-blue surprise (bar timing). Yes, the AAA benchmark means less than it once did, especially since the US downgrade in 2011. Hence, forced selling is likely to be minimal. Still, we can think of no reason why demand for gilts should go up now that they have lost the AAA rating with one agency, so the risks only lie in one direction.”

The report argues that unless the Bank of England steps up acquisitions of gilts, the private market will have to absorb on average £13 billion of gross supply each and every month in the coming years, anchored by non-resident buyers.

However, the analysts add: “for non-residents to buy additional gilts, they must first allocate money to GBP to begin with. And if that is seen as a poor currency to invest in, then there needs to be a correspondingly large increase in UK yields, relative to its peers, to make up for that.”

In conclusion, there is unlikely to be a mass selling of gilts but yields could tick up, reinforcing the allure of more QE, the analysts conclude.


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