Treasury's austerity hawks risk pushing the UK into a Japanese-style deflation trap

UK sovereign debt is trading at negative yields all the way out to seven years’ maturity

British two-year bond yields fell below Japanese levels last week. The markets do not believe in a swift recovery Credit: Akio Kon/Bloomberg

Britain has seen a more dramatic lurch towards negative bond yields than any other major country since the onset of Covid-19, radically transforming the structure of the UK debt market almost overnight. 

Bank of America says yields on £450bn of sterling sovereign debt have fallen below zero for the time in history. The speed of the move has been breathtaking, and signals the real risk of a Japanese-style deflation trap for the UK economy. 

It comes despite a budget deficit exploding towards £400bn this financial year. The silver lining is that the Treasury can cover the immediate cost of the Covid-19 shock without having to worry about an exodus from gilts.

UK sovereign debt is trading at negative yields all the way out to seven years’ maturity, replicating the pattern in the eurozone over the last four years. Two-year gilt yields fell to minus 0.13pc last week, briefly dropping below comparable Japanese levels. High grade corporate debt in the UK has been marching in lockstep, with borrowing rates rapidly honing in on zero.   

Bond yields have been slipping across the world as debt markets price in a truncated U-shaped recovery from the pandemic, one that may entail a long painful return to normal once households and firms start to tighten their belts. The message from the bond vigilantes is in a stark contrast to near-perfect V-shaped recovery priced in by exuberant equity investors. 

Over $12.4 trillion of global debt is currently trading at negative yields but the figure is still $2 trillion shy of last year’s peak. It is British debt that has been “re-rated” most suddenly, converging  with the “Japanese bloc” since April. “The stand-out has been the UK,” said Barnaby Martin, Bank of America’s credit strategist.

The plunge in yields can be read in different ways. The Bank of England is soaking up the entire debt issuance of the Treasury, distorting price signals. The US Federal Reserve and the European Central Bank are doing much the same thing in their respective zones.

The Bank of England has opened the door to sub-zero policy rates under the new Governor, Andrew Bailey. “They always used to say negative rates are ‘not for us’ so this is potentially a big change to the toolkit. Financial markets run with a scenario like that in the background,” said Mr Martin.

Markets are also anticipating a switch to Japanese-style “yield control” by a string of central banks, the last step on the path to total financial repression. This has pulled US Treasury yields back down to lows seen during the flight to safety in late March, although investors are still betting that the US will shake off the post-Covid malaise more easily than the UK or Europe. 

However, there is a much darker side to this bond rally. Earlier bouts of quantitative easing led - paradoxically - to a jump in global yields. Investors anticipated an accelerating recovery and a revival of future inflation. 

Something has changed. The law of diminishing returns may have set in or the debt shock from the pandemic has simply overwhelmed the stimulus. “The market is telling you that there is not going to be a V-shaped recovery,” said Mr Martin.

The different pattern this time is ominous, and no more so for Britain, where loose talk of austerity is already starting to infect sentiment. The Office for Budget Responsibility said last week that the UK public finances are on an “unsustainable path”. It mapped out a bleak future of austerity, including £60bn of probable tax rises.

An internal document from the Treasury in May floated a public-sector pay freeze, cuts in welfare and spending, and tax rises, together worth £25bn to £30bn a year. 

It even went so far as to warn of a “sovereign debt crisis” purportedly akin to 1976, when the UK had to turn to the International Monetary Fund. The claims raised eyebrows. The UK did not have a debt crisis in the 1970s. It had a misaligned currency in the era of fixed exchange rates, which is a different matter.

The rhetoric from the Treasury and the OBR suggest that the ideology of the UK policy establishment has not changed over the last decade. This is despite criticism that austerity was premature and pushed beyond the therapeutic dose (especially cuts to public investment), and therefore proved self-defeating even on its own terms. 

The dominant view among global economists and bond investors is that fiscal tightening is a false cure in a world of zero-rates, deficient demand, and chronic deflation. It can have the perverse effect of raising the debt ratio even faster through the denominator effect.

“It seems the ‘Treasury view’ is alive and well,” daid Professor Roger Farmer from the National Institute of Economic and Social Research. “A tax hike in the current climate will inflict unnecessary damage.”

Prof Farmer says there is nothing inevitable about such austerity. It is a “policy choice” and it comes at a crucial economic juncture. 

The alternative is to take advantage of low global borrowing rates for an investment blitz in projects with a high multiplier, boosting the country’s long-term dynamism in a bid to outgrow the debt burden. Chancellor Rishi Sunak leans in this direction but his department seems to be digging in its heels. 

The immediate worry is that bond markets may already be acting on UK austerity signals, pricing in a deflation pathology that then becomes self-fulfilling and potentially dangerous. The risk is unintended monetary tightening where inflation expectations collapse even faster than the Bank of England can keep stimulating the economy. This has the effect of lifting the “real” cost of borrowing, even as conditions deteriorate. 

That way lies the Ninth Circle of Hell for policy-makers. The Treasury must expect a ferocious push-back against its orthodoxies this time, and not just from the economic and political Left. The OBR itself is going to be put under the microscope.   

For investors, global “Japanification” creates its own opportunities as well as disastrous pitfalls, judging by moves on the Tokyo exchange over the last twenty years. Bank equities have been in a slow death spiral ever since the zero-rate era began, dropping 70pc with torrid cyclical rallies along the way. Real estate has fallen 20pc. 

Health care stocks have soared 300pc and government bonds have racked up 170pc over two decades. “The market will place great value on companies that generate stable profits with low earnings volatility. In Europe, we find that the ‘Japanification’ bid is likely to gravitate towards euro utilities, healthcare, telecoms and consumer sectors,” said Bank of America

Goldman Sachs has its own turbo-charged variant of this, recommending Europe’s unloved utilities. It screens them for “climate champions” that will benefit most from Europe’s green deal and from tougher rules on emissions.

The bank expects €7 trillion of eco-focussed investment this decade in the EU, and almost half will go to those utilities that have made the switch to renewables. Much the same applies to UK utilities as the Government puts into place its net-zero regime.

The other Japanification winner is corporate credit. Bank of America says yields will keep dropping as investors try to escape the “no-go zone” of sub-zero rates.

The European Central Bank has signalled that it will buy many more industrial and commercial bonds (though not bank bonds), making the trade almost irresistible for fixed income funds. Some €160bn of European company debt is trading at negative yields. “We think it will go to €500bn soon,” said Mr Martin.

Whether free loans for companies actually lifts the real economy off the reefs is another matter. Fiscal policy is the name of the game now. The omens are mixed.