As G(u)ilt(y) as Greece?

The past couple of weeks have witnessed yet more UK-bashing, with Gilts underperfoming significantly, as the Bank of England has remained dovish in the face of rising inflation, fiscal concerns have spilled over from Greece and the rest of the iPIGS, opinion polls have moved to indicate that the UK is heading for the much-hyped "hung parliament", and economists have written contradicting letters to the Sunday Times & FT.

Professionals have pointed to the (undeniably) large deficit numbers and the fact that the Bank of England is no longer on the bid, and thus, encouraged by the successful speculative attacks upon Greece, many are declaring the UK as "next". Certainly, I share their worries. The deficit is unsustainable and something needs to be done about it, and will be done about it. Regardless of what Gordon Brown says in his electioneering, there is already a consensus within Westminster with regards to reigning the deficit in. Although, undoubtably, markets would react unfavourably on the news of a hung parliament, I believe that such a dip should be bought. The UK has a long history of successful fiscal consolidation, and surveys show the population is onboard. But all of this is an issue for another day - probably the 6th May.

More currently, Gilt valuations look stretched, with Gilts trading as wide to Bunds (see chart below) as they have since 2005 when UK rates were significantly higher than EU rates. So adjusting for this, it is clear that they are very cheap for one reason or another.

Looking at Bonds vs OIS is perhaps a better way to gauge value as it represents the difference between what the bond yields and the (more or less) risk free way of funding them overnight. The below chart shows 10yr Gilts vs SONIA (green), the GDP-weighted EMU 10yr yield vs EONIA (orange), 10yr Bunds vs EONIA (pink) and 10yr USTs vs OIS (white). Prior to the introduction of QE, Gilts traded somewhere in between the overall EMU spread and the Bund spread at similar levels to the US (although this widened somewhat as RBS and Lloyds went into meltdown in January 2009). As I'll discuss below, the Gilt/Sonia spread has been affected by QE, but the dramatic widening of this spread since August to now be right at the same levels as the EMU average is notable. Regardless of whether the UK really is AAA or not, it is clearly not the several notches lower that the EMU average represents. In fact, Gilts trade wider to Bunds than Italy or Spain.

Next, let's zoom in on the Gilt/Sonia spread to look at the effects of QE (see below). The introduction of QE in March was followed by a sharp tightening in the spread, representing the increased demand for Gilts coming out of the BoE (initially appearing to be ~50bps). The tightening went further (~15bps) as the BoE extended the plan. From the summer onwards the market anticipated the end of the QE program and unwound the richening in Gilts as this demand was priced out. But the spread has widened something like 40bps further. Much of this move can probably be attributed to fiscal/election issues discussed above, but with speculative positioning looking short, any positive newsflow is likely to lead to a short-covering rally. Indeed, opinion polls are yet to capture the response of voters to the latest reports of Brown being a bully.

Regarding the amount of Gilts that the DMO needs to sell, many neglect to account for the fact that the private sector is currently running a financial surplus as a result of a need (real or perceived) to rebuild balance sheets. In fact, the country as a whole is likely to record a Current Account surplus (see chart below - currently a deficit of 1.28% as of Sep2009), meaning that - as in Japan - there will be significant demand for Gilts from banks intermediating the private sector surplus. This is a key difference with Greece (C/A ~15%) and the rest of the iPIGS - the UK does not require much external funding. And finally, UK monetary policy has been eased aggressively and the exchange rate has depreciated markedly, providing a very large amount of stimulus, providing a support to growth that the EMU periphery have not had.

Now, there is a 50yr syndicated deal to be priced tomorrow and a 10yr auction on Wednesday that have a combined duration of around 110,000 contracts. Use the dip to scale into longs vs Bunds.