Brave forecasts behind last week’s U.K. Budget
It takes different views to form a market, and I seem to be in a distinct minority in expecting long term government bond yields to rise significantly. The Chancellor certainly disagrees with me, as his path to a primary surplus largely depends on a fall in the debt service cost. This article explains why I believe he will be disappointed and what the implications are for long-term investors.
Servicing government debt in 2022-3 cost over £100bn or 11% of all public expenditure (4% of GDP). This figure is around two and a half times the £40bn average between 2010 and 2020; and those numbers were flattered by the Bank of England’s Asset Purchase Facility which effectively converted higher cost gilts into lower cost short term borrowing.
Over the next five years, the Treasury forecasts the cost of debt service will fall to around £90 to £100bn per annum. This is how the Chancellor has balanced his budget and kept his self-imposed rule of a primary surplus within five years. Behind lie some brave forecasts over this period: inflation will stay below 2%, reducing the cost of servicing index linked gilts (about 25% of total debt service costs) by about £10bn in the next two years; bond yields will come down by about 50basis points (0.5%); interest rates will come down by 0.7%; and the stock of outstanding debt will fall from 100% to 90%.
The path to a primary fiscal surplus is narrow
I can accept the first of these three assumptions, at least in the near term, when there is likely to be a disinflationary pulse from China. I am less certain that inflation will stay below 2% further out, and in the longer term there is a clear risk of it being much higher.
There may indeed be a small fall in interest rates, though if so it will be driven by the fragility of the financial system (U.S. commercial property being the rabbit in the headlights here). This would reduce the cost of his shorter- term debt. I am sceptical that bond yields will stay as low as they are, as I explain below. And without significant primary surpluses I do not expect to see any material reduction in his overall debt levels, clearly a major input into the debt service cost.
My main point is that the Chancellor has a narrow path to tread to avoid debt service costs rising instead of falling. A number of commentators have pointed out that he has less than £9bn ‘headroom’ to achieve a fiscal surplus by 2028/9. But that is more than outweighed by the £11 to £17bn ‘improvement’ in his debt service cost forecasts since the Autumn statement resulting from more favourable forecasts. If any turn out to be misplaced, he will not achieve a primary surplus because the cost of financing his debt will increase significantly. As they are all connected, it is much more likely that he misses all of them.
I should stress that the Chancellor’s balanced budget is not irresponsible; for example, the U.S. is likely to run with deficits of up to 7% over the next ten years or so because of its fiscal incontinence and is headed for a far worse place. But, even if his forecasts turn out to be accurate, the reduction in the U.K.’s debt levels will be immaterial.
Why debt service costs will rise, not fall
U.K. Government’s level of debt today at 99% of GDP is already far higher than the 35 to 40% considered reasonable prior to the Global Financial Crisis. This matters: a government can always issue bonds to finance a budget deficit or to refinance existing debt, but markets will dictate the price – in this case the bond yield. Since the Second World War there has usually been a following wind to help governments: higher growth and therefore tax receipts (1950s and 1960s) to keep debt levels down, inflation to reduce the real value of debt (1970s through the 1990s) and rock-bottom interest rates (post 2008). It’s hard to argue that any of those will be in place going forward in the West.
Worse than that, there are factors which are simply out of any chancellor’s control, most obviously bond yields. This is why I do not believe that the forecast of a fall in debt service costs over the next five years is realistic. The issues behind this are much more profound than simply keeping to his self-imposed rule.
What could derail his forecast?
Here are some of the things which could go wrong:
Markets could demand higher yields on government debt. Higher inflation is one reason, but it could also be driven by a realisation that the U.S. is on a clearly unsustainable fiscal path, with the Congressional Budget Office itself predicting that debt/GDP as a ratio will rise inexorably to 130% by the early 2030s and 250% by 2050. There are sound technical reasons too why bond yields should rise (e.g., the term ‘premium’ should normalise, and at least in the U.S. the Federal Reserve is deliberately suppressing Treasury yields by using non coupon-bearing sources of funding.) Our friends at CrossBorder Capital suggest that yields should be at least 100 basis points higher for these reasons alone.
Political necessities could derail the Chancellor or his successors. That might come from having to increase expenditure (e.g., defence, justice, health) or being unable to raise taxation. Every pound spent on debt service is a pound unavailable for other need, so there is the potential for a vicious circle to develop.
The Bank of England may choose not to reduce interest rates. Four to five percent has historically constituted a ‘normal’ range for interest rates, especially when inflation is at 2%. Anything lower than that might be considered a return to Quantitative Easing.
Economic growth might disappoint. The OBR forecast is well under 2% over the next five years, but even that is looking optimistic.
The long-term implication is monetary inflation
Once the vicious circle of higher debt service cost begins, together with the level of public debt it will derail the fiscal arithmetic. This is why the Chancellor’s numbers are unlikely to add up. There are actions the authorities can take to reduce the cost: for example, the Bank of England can resume Quantitative Easing; they can ‘encourage’ institutions to purchase gilts using regulations or other pressure; they can finance more short-term and less long-term. But it will take exceptional political or banking leadership (think Paul Volcker and Ronald Reagan) to turn it round by conventional means.
For investors, the implication in the long-term must be monetary inflation. I say this not only because, other than default, inflating away the real value of their debt will prove the only recourse left to western governments. But also because a return to the short-term palliative of Quantitative Easing seems to me the most likely prospect.