PWLB rates, the global economy and your next TMS

Leigh Culf is a consultant with Sector Treasury Services Ltd 

Now that the season of merriment is past, it is time to turn our thoughts to treasury management strategies for the coming year.  Since the start of the year, we have seen a sharp rise in PWLB rates.  Is it time to seriously consider taking new PWLB borrowing before we see even higher rates? As ever, if I could give a definitive answer to this proverbial $64,000 dollar question, I can assure you I would not be sitting at this desk writing this article when I could be making a fortune in other ways! However, a treasury manager’s job is to identify and manage risk.  So no cop-outs please from this task!

My first thought is acknowledging that we have seen a considerable turnaround in the equity markets with confidence returning on a wave of rising sentiment that ‘things MUST get better’.  Good news for equities is bad news for gilt prices so hence the rise in gilt yields.  However, a further downer on UK gilts has been a surge in confidence that the Eurozone crisis is “now behind us” as President Hollande of France so pontifically pronounced.

Mario Draghi (head of the ECB) has performed a masterful stroke by saying that the ECB would buy government bonds without limit of countries in the Eurozone which request a bailout.  That has prompted a near miraculous turnaround in sentiment towards Spanish bonds, as evidenced by last week’s successful Spanish bond auction.  This then has eased the pressure on Spain to seek a bailout in the first place as current new issues of debt are back down to tolerable yields.

However, Spain has to raise over €100bn of new loans in 2013 so there will be plenty of opportunity during the year for markets to have second thoughts.  Consider in particular, that Spain’s unemployment rate is very close to Greece’s at about 25%.  The collapse of the property market and the construction industry since 2007 has caused this blowout in unemployment.  It is very difficult to see how Spain can get this figure down significantly other than by looking over a decade or two to develop new alternative industries.

This has obvious implications for depleted government tax revenues and increased government expenditure on benefits etc. with equally obvious implications for major difficulties in getting the budget deficit down to anywhere near 3% within a few years.  Spain is too big to be allowed to fail for the Eurozone but equally, it is so big that the cost of a major bailout could prove to raise issues that will cause politicians in countries who will need to pay into the coffers, to quake at the knees. There is, therefore, a huge confidence issue facing us in 2013 which the markets are currently choosing to downplay, based on the determination shown by the Eurozone in paying whatever the bill to keep Greece in the Eurozone during 2012.

However, populaces do have a pain threshold where the willingness to tolerate yet further austerity can become one bridge too far before democracy itself comes under threat.  While Greece has dropped out of the news headlines recently, there is a considerable lack of confidence that the Greek government will deliver on its targets to reduce the size of its deficit so 2013 could produce more worries from that direction, let alone Portugal and Cyprus causing erratic heartbeats too.

Closer to home, the fact is that gilts have currently lost some of their safe haven status due to the increase in confidence that the Eurozone is now on top of the problem with the debt crisis.  Market concerns have also increased over gilts recently due to the prospective Governor of the Bank of England from June, Mark Carney, musing about changing the inflation target from 2% CPI to one based on nominal GDP so as to help promote economic growth.

We have also had concerns raised over a potential switch of index linking of inflation indexed gilts to a revised, and lower, form of RPI.  Although this has now been quashed, we do have a new measure RPIJ, which everyone acknowledges is more accurate than the flawed methodology of RPI.  In addition, the three credit rating agencies are all reviewing the current AAA rating of UK Government debt due to the lack of growth in GDP in 2012 depressing tax revenues and derailing the original timetable to reduce the annual deficit and to start reducing total government debt; any downgrading could add further to the undermining of gilt prices.

This is all depressingly adding up to upward pressure on gilt yields and PWLB rates.  So could further quantitative easing come to the rescue to keep gilt yields down? This month the Bank of England Conditions Survey gave us an unequivocal insight that the Funding for Lending Scheme (FLS) HAS kicked in and resulted in a sharp increase in the availability of credit, both for corporates and households.  However, it also revealed that the demand for credit is weak, particularly from corporates.

We, therefore, have to acknowledge that the banks were right after all; the core problem in the UK economy is a lack of demand for credit, not supply.  This adds up to a picture of the MPC now being akin to a heavy weight boxer who has thrown all his punches and while he may just about summon up enough energy to throw one last haymaker (doing more QE in February or May), that will be all it can do before collapsing on the floor and giving up the fight to promote growth in the UK. It is, though, also possible that the MPC could decide that QE is now such a weak weapon that they may decide not to use it for a final time.

It will, then, be up to the Government to play tag and to step into the ring by resorting to good old traditional Keynesianism by trying to stimulate demand directly, e.g. by promoting infrastructure investment or a major increase in desperately needed house building, but – and herein is the major caveat – without adding directly to its own total expenditure and increasing the size of the annual deficit (which would unsettle the markets and rating agencies). Hmm!

So, the Government is treading a tightrope in having to maintain market confidence in gilts at the same time as fearing the total bill for interest payments on gilts ballooning if market confidence in the UK was to weaken – which would completely undermine any attempts to get the annual deficit back down to reasonable levels.  Of course, once market confidence in a country evaporates it can be hideously difficult to get it back again.

So, what could rescue world growth in 2013?  Well, China seems to have found a second wind towards the end of 2012 which is encouraging.  Also, the US housing market has started a solid recovery which will boost consumer confidence.  The US will probably stumble its way through the fiscal cliff crisis and trundle along at around 2% annual growth, helped by the surge in cheap shale gas and oil. And Japan is trying the umpteenth bout of government paid for stimulus which might even possibly drag the economy into growth.

As for the market makers themselves, a majority of fund managers seem confident that now is the time to get out of bonds and into equities and UK savers have no incentive to keep cash in ultra safe deposit accounts due to the now miserable deposit rates available, primarily because of the cheap funding available to banks through the FLS.  Don’t discount, however, a number of potential wild cards that could upset the apple cart like the German general election, the Iran – Israel situation, Syria, North Africa and the Senkaku islands dispute between Japan and China.

So, to sum up, the current spike in PWLB rates is based on upbeat economic sentiment that primarily arise outside of the UK.  But then again, looking further forward into 2013, any wobble in confidence over Spain and both the ability and willingness of the EZ to provide support without limit to Spain (and other debt-aholics), could advantage UK gilts, leading to a rally in gilt prices and a fall in yields as the relative safe haven qualities of gilts (in not being EZ debt) come to the fore once again.

So, in effect, PWLB rates could go up, sideways or down depending on which of the above areas predominate.  Most probably, there are more factors pointing to a downside movement in yields but you wouldn’t want to bet the ranch on that outcome.  A strategy of controlled risk management would appear appropriate.  In any event, treasury managers are going to require some good luck to go with their considered decision making.  Now where did I put my bottle and my pills…