22 January 2011

UK Interest Rates as UK Debt Passes the symbolic GBP 1 trillion mark

This week, on 17th January 2011, at 17:15 the UK national debt has reached GBP 1 trillion  (at least officially, as unofficial estimates put it at GBP 8 trillion, of which pension obligations represent GBP4 trillion and bank bailouts further GBP 2 trillion, but we leave this issue for another time).  Just one week earlier I read that due to higher than forecasted inflation figures we expect rise in interest rates, and having myself a seven figure mortgage linked to the BoE rate, this issue is very much a relevant news to me, as in many ways in terms of the debt levels I find myself in the same shoes as the UK government does.

Until now I was relying on my basic knowledge that UK government spends GBP42 billion a year on debt financing costs alone, and faced with GBP152 billion deficit (after GBP 6 billion of widely publicised Cameron cuts), and on total debt of GBP 1 trillion, I was under impression that the government has got itself into a Japan like debt trap (not liquidity one), where it needs low interest rates to be able to afford its very own debt interest payments.  However, I decided to dig deeper into the reports of the Debt Management Office to see exactly what their positions are like.  I have done it for many EM governments, but its been a while since i looked at the developed economy like UK.

What I discovered was highly impressive (not only in the degree of openness).  The average modified duration of UK debt is 8.66 years.  Only 23% of the bonds are due in the next three years, a number similar to the proportion of index linked bonds.  Add to this the fact that 30% of the gilts are owned by the foreign investors, and you might start to realise that the UK government is actually very well positioned for the upcoming high interest rate / inflation environment.  Contrary to my earlier belief, the reality is that the government costs of borrowing will be affected only slightly should BoE say increase its rate to even 4% (of course gradually), especially if the result of this will also be in the form of savings from the decreased coupon payments on the index linked bonds.

Having realised this I can see that my 100% floating rate position in my debt is actually totally different to the well managed long duration position of the Bank of England, however unlike the government and my clients, I have very little tools to use to prepare myself for this coming shift, apart from of course working harder to brace myself for the coming 4% BoE interest rates.

Looking back, there was very good reason why during the last UK elections I stayed up all night hoping to see Gordon Brown retain power, as I now feel that this government, with the PM educated at Eton, his deputy at Westminster and its "pov" Chancellor at St Paul's, will be doing much more to protect its conservative electorate, who save the cash rather than irresponsible borrowers that use their credit cards (of which rates are based mostly on credit spread rather than borrowing cost anyway).  Add to this the not to be ignored political element, that despite the horrific statistic on public debt, the small savers still represent a majority of the population, and we can now foresee, neglecting of course the independence of the BoE, that the rates will need to rise, even if there will be a risk of the double dip recession.  The only losers from this will be the banks that depend on the overnight funding rates on their borrowings are repo deals, but judging by their recent results, this is also hardly a problem.

Luckily however, due to the moral hazards listed earlier, I still consider my interest rate position to be somewhat naturally capped at say 10%, as if we stress model the government finances at this level, it may be that the extra GBP 60bn that would be needed to service the cost of debt would outweigh the real capacity of the government to generate savings, especially given its current deficit, lading to debt simply spiralling out of control, with the only solution to print yet more cash (QE programme).  Yes, this controlled Zimbabwe like scenario is still something very much on agenda, but we need more borrowing, more deficit, and perhaps the return to power of Gordon Brown II.