Will the next UK government be out of power for a generation?

Mervyn King has famously said that the tax increases and spending cuts that would be needed to plug the UK's budgetary hole would be so unpopular that they will keep the party that introduces them "out of power for a whole generation". Aside from the point that this is just the latest in a long line of communications incompetence and political-meddling from the Bank of England's Governor (yes, I'd sack you, Merv!), does he have a point?

The real question here is "what is the impact upon growth and employment of a significant fiscal consolidation?". The widespread and off-the-cuff answer to this is usually "well, obviously growth is going to collapse and unemployment is going to sky-rocket". Nearly thirty years have past since "Thatcher's cuts" of the early-80s, and the political, economic and media narrative appears to treat the early-80s as being a single event caused by "Thatcher's cuts". As a result, it is commonly accepted that fiscal contractions are terrible for growth, employment and, by extension, government popularity. Indeed, many cite the deep unpopularity of the Conservative government in 1981 - the time when the Lib/Lab Alliance was posting approval ratings in the 50%+ range. Again, the common parlance is that the Falklands War was the only reason that Thatcher was re-elected. The latter point may well be valid, but an analysis of why the Conservative government was so unpopular in 1981 is instructive.

As with most things I rant about, this is a case of conventional wisdom not getting the facts right. The below chart shows quarterly GDP around the 1979-81 recession. The red line is where Geoffrey Howe announced his austerity budget (in March 1981) and the 1980s fiscal consolidation began. So if the government was deeply unpopular in 1980-81, it was clearly not as a result of Howe's austerity budget.

The real answer here, of course, is the UK's embrace of Monetarism and its desire to "break the back of inflation". The Second Oil Shock, triggered by the Iranian Revolution and President Carter's market-based reforms lifting energy price controls, resulted in a second bout of double-digit inflation (see first chart below). In just under a year, the government had raised the Bank of England base rate by 500bps(!) to a high of 17% (see second chart below). Similar measures were implemented across the Western world as central banks tightened monetary policy in their attempt to gain inflation-fighting credibility. With both real and nominal interest rates pushed to such high levels, it is unsurprising that many countries suffered deep and painful recessions. These recessions had a very unique characteristic in that they forced economic restructuring as traditional manufacturing businesses began to feel the impact of the rise of Japan - an ex-colleague dubbed the US version "The Great Rust-Belt Restructuring". The UK's attempt at economic restructuring and the associated Miners' strike in 1984-5 was completely separate from the fiscal austerity program, however, it is grouped into the same set of policies enacted by the Conservative government. It is important to maintain a distinction between these events. The fiscal consolidation plan came after the Monetarist policies (which are unlikely to be repeated now) which triggered the sharp 1979-81 recession, after the government's popularity in the opinion polls had fallen deeply, and after the recession had ended.


But what about the effect of fiscal tightening itself? Goldman Sachs have put together an excellent paper (Global Economics Paper No:195 - "Limiting the Fall-Out from Fiscal Adjustment", Ben Broadbent & Kevin Daly) that looks at 24 OECD countries' fiscal consolidations over the past 35yrs. The common criticisms of such studies are that conclusions drawn from them may be reflecting other factors, such as FX depreciation, falls in interest rates/bond yields and the stage in the economic cycle (the more cynical view is that Keynesians and politicians have an interest in fiscal easing and prefer to criticise any policy that withdraws stimulus early on in a recovery - Krugman, Stiglitz, and the LSE fall under this bracket!). Goldman Sachs have attempted to control for these effects, and came to some pretty striking conclusions:

• Expenditure-driven plans are much more successful in reducing debt levels (see first chart below).


• Tax-driven plans have hit growth hard (with a 1% increase in the cyclically-adjusted tax-to-GDP ratio taking an average 0.9% off GDP per year).


• Expenditure-driven plans actually boosted growth [no, that is not a typo!] (with a 1% cut in the cyclically-adjusted expenditure balance adding an average 0.6% to GDP per year).


• Business investment recovered very strongly, and was much more important in the growth rebound than exports (see second chart below). More on this very important point below.
  

These are pretty remarkable conclusions, supported by a recent OECD paper and also by a recent UK Treasury paper. They conclude that the optimum fiscal consolidation program is 80% expenditure-driven and 20% tax-driven. This is the stance held by the Conservative party (Labour plan 67/33), if only articulated to a "fluffy cloud" degree for political expediency. Given the above evidence (as well as that of above-trend growth in the UK from 1981-87), it is likely that many will be surprised by just how little growth is affected by these austerity plans.

Back to business investment point. When there are severe fiscal imbalances, evidence suggests that the both consumers and businesses save on a precautionary basis, expecting future tax rises in a form of Ricardian Equivalence. It is therefore plausible that if a government cuts spending, then the probability of such tax rises in the future falls, and thus pent-up demand from consumers and businesses is released, driving the recovery. This is a form of "crowding in". Such moves may also loosen monetary conditions by reduced fiscal premia on long term debt or via FX depreciation (as the government is no longer spending on domestic "stuff" and workers, system-wide unit labour costs fall, lowering the Real Exchange Rate, and increasing the competitiveness of the private sector). On this point, it is important to remember that a government deficit is the mirror of the private sector's (including the external sector) surplus. For the UK, the external sector is zero (the Current Account is currently balanced - this is a KEY DIFFERENCE with the PIGS, all of whom run Current Account deficits and rely on external financing), and therefore, by equivalence, the private sector is saving at an unsustainable rate. The below chart shows UK Business Investment at an historic low of -23.5% y/y (ignore the 2005/6 spike which was a one-off accounting issue) and also clearly shows a very large bounce in business investment during the years of Howe's fiscal consolidation. Given that there is much uncertainty regarding the election and sovereign credit rating, it is very possible that corporates are in a state of "wait and see" until there is clarity post-election. It is also worth remembering that business investment in both the UK and US has been subdued since the DotCom boom, and a notable feature of the current US recovery has been that businesses have been ramping up investment. Post-election, it is highly likely that this will occur in the UK, in tandem with fiscal consolidation in the manner demonstrated in the GS study above.

The final point I want to address is the view that fiscal consolidation implies a weaker FX rate and that post-1981 the Pound depreciated significantly. As discussed above, this economic phenomena operates via unit labour costs cheapening the REER. The below chart shows General Government Consumption as a share of GDP (white line), and the Bank of England's Calculated Effective Exchange Rate (Orange/Green - two overlapping series) lagged by six months. It is clear that over time there is a broad relationship between the two: as the government's share of the economy increases, it pushes up labour costs and crowds out the private sector (thereby increasing the Real Exchange Rate), and as its share fall, the opposite effect occurs. Obviously, the relationship is not completely tight over time (and far from the only driver of the exchange rate), but broadly speaking this effect has been observable, especially in the 1980s. More recently, it appears that Sterling anticipated this effect in 1996-7 as it became more likely that Labour would be elected. I think the large disconnect since 2008 is a combination of the bank bailouts not representing actual expenditure, but instead loans, and the market already pricing in the likelyhood of a significant fiscal contraction in the coming years. On this basis, therefore, it is hard to argue that GBP should weaken further as the UK tightens fiscal policy. As a corollary, it is remarkable that Gordon Brown's Statism makes the 1970s look pretty tame by comparison, with Government consumption as a share of GDP the highest on record (since 1960).


As an aside, was the fiscal effect the only phenomena in the 1978-85 period? The below chart shows the BoE Calculated Effective Exchange Rate (orange), and the white line below shows the spread of the BoE Base Rate to the IMF Special Drawing Rights interest rate (which is an average interest rate for IMF shareholders) lagged by 6months. From 1978-80, the UK boasted a spread of as high as 930bps over the SDR-average, and as a result the Pound appreciated significantly, reversing all of its losses on this CEER-basis since 1974. Over the first half of 1981, as the recession crimped inflation, policy was loosened (as it was globally). For the next few years, this spread oscillated around +/-200bps. Perhaps one of the main reasons that the Pound fell from 1983-84 was that the Fed tightened policy by 313bps, but UK inflation remained relatively benign in that period. To conclude here, it's possible to see the fiscally-driven weakening, but it is arguable that this was not necessarily the entire reason why GBP traded weakly during this period.


I digress...

The point of this piece is to demonstrate that fiscal consolidation is not necessarily ball-crunching and, if enacted in a sensible way (i.e. the 80/20 rule), can actually act to crowd-in private sector investment - which will invariably create new, more economically useful jobs than those that are lost in the public sector. The misconceptions around the early-80s "Thatcher cuts" have served to create the impression that fiscal consolidation is only a bad thing, and the anti-Tory narrative of the Left over the past 30yrs has encouraged this perception. But the real pain in the early-80s was in response to the very significant monetary tightening from 1979-80, and in the mid-80s in the North as a result of Thatcher's war with the National Union of Miners. Neither of these two events is going to occur this time around because the BoE has inflation-fighting credibility (though, Mervyn King is doing his best to wreck this!) and there aren't any miners to fight. Of course, this is not to say that public sector unions will not fight these cuts, but provided growth in aggregate is not hurt, it is unlikely to harm the government's approval ratings too much (c.f. 1987 election on this point).

So, to conclude, I think Merv is wrong (though, I think he's wrong about a lot of things...!).

The Bill Gross Effect

Since the beginning of the year, but particularly over the past month, Bill Gross and Ed Ball's brother, both of PIMCO, have been encouraging professionals to be underweight or short Gilts on the back of a hung parliament and general "the UK is history" (haven't we heard that before) story. Now this is interesting because it has not only resulted in Gilts weakening with respect to Bunds, but also resulted in a very large underperformance of the Gilt Future and its CTD.

In the below chart, the underperformance of Gilt Futures (and CTD) since mid-March can clearly be seen. Yellow line is the 10yr Gilt/Bund benchmark yield spread, the Orange line is the spread between the two CTD yields, and the White line is the ratio of the futures prices.

What is even more interesting is that in the same period, the underperformance of the CTD is marked against the curve. The below chart shows the spread of the yield on the CTD against the benchmark 10yr Gilt. Since mid march there has been an exceptionally large 13bps cheapening.

The point here is that the above evidence points to the conclusion that much of the recent weakness in the Gilt market and steepening pressure has been entirely futures led, and is thus very likely to be speculative and potentially vulnerable to a wash-out.

The Brussels (lack of) Consensus

Larry Summers once said:

"When markets overshoot, policymakers must overshoot too"

This "shock and awe" philosophy has been at the heart of the Washington Consensus that developed during the 1980s and 1990s. Hank Paulson in 2008 failed to follow these principles in dealing with Bear Stearns, the GSEs and Lehman Brothers, only finally "over-shooting" with the introduction of the TARP. The US policy response up to that point had failed to deal with the problem adequately, but the unveiling of a program to deal with the systemic problem was a clear "overshoot". But by then, it was too late to avoid the large systemic contagion as a result of the administration's prior policy. Nevertheless, as markets gained confidence that the banking system had been underwritten and that a Japanese-style malaise had been avoided, confidence was restored.

There appears to be a vast divide between the Washington Consensus and the Brussels Consensus. Well not so much a divide, as more like the latter does not exist! An example:

*VAN ROMPUY: EU CAN HELP GREECE IF MARKET FINANCING INSUFFICIENT

A damp squib from a man with the personality of a damp rag and the appearance of a low-grade bank clerk (with apologies to Neil Farage of UKIP).

But more seriously, I am astounded by the inability of the EU to come up with an adequate policy response. It is incredible that Greece has decided to market itself as an EM issuer when it has such a large amount of debt to finance over the next few years, to an investor class that is highly proficient with respect to debt restructuring. It seems barmy to expect this to result in anything but higher yields. The German stance with respect to only lending to Greece at market rates only serves to compound the problem - Greece last borrowed from the market at around 6%, a rate that ensures fiscal insolvency very rapidly.

The price action of Greek bonds (see below) and general commentary from market professionals suggests that many now are resigned to the prospect of a Greek debt default and restructuring. As one astute person commented to me, the markets appear to have an erie sense of calm about them, as if such a default would have no contagion whatsoever. Perhaps it is one of those "the market needs to see it" type of events and until then it will be business as usual?

In January and February, the view of contagion to the rest of the PIGS was practically universal, and markets moved accordingly, to some degree. But with the threat of CDS regulation and the EU finance leaders' initial statement on Greece that all died down, presumably, because it gave the impression that it was a more broad mechanism for assisting the other troubled states. However, the Greek situation just keeps getting worse. Perhaps the market is right to ignore them, judging that the Greeks are a special case in that they have such a poor track record with respect to implementing reform/reporting statistics etc., and the others will be fine?On the other hand, I have a hard time believing that a Greek restructuring would have little contagion. As a friend reminded me today, the fiscal contagion to the rest of the Eurozone is multiples of Argentina.

I was definitely one of the optimists early on (as per my earlier posts on Greece), but that was based upon the premise that the EU had learned the lessons of Paulson's utter screw up with respect to BSC/FNM/FRE/LEHetc and would come up with some sort of systemic programme to avoid such contagion. But they can't even deal with the first entity!

Are the Germans likely to change their tune on market rates vs subsidised rates? Perhaps, but it is probably already too late, given that GGBs trade like LEH stock did in those last two weeks.

Repo Releveraging

In Q1, Primary Dealers have re-leveraged significantly by about 16% in aggregate judging by outstanding Repos (see chart below). This is about average for the past 5yrs (excepting Q1 2008 when large off-balance sheet exposures from SIVs were brought back on-balance sheet). However, it is worth noting that outstanding repos are now back to the levels of a year ago.

There are two possible conclusions to make from this development:

• either dealers have been loading up on the rates carry trade, or


• balance sheets are no longer as constrained as they have been over the past year, and this balance sheet expansion argues that aggregate credit is now expanding.

I am obviously talking my book now, but if it is the former, then the rates market is vulnerable to a positioning unwind, and if it is the latter, then growth is likely to be significantly stronger than expected and Fed tightening a lot closer. My personal view, however, is that it is the former, and the price action in rates markets would support this view.

UK Elections for Investors

I've been meaning to write something on the election for a while, so thought this poll (http://www.timesonline.co.uk/tol/news/politics/article7054655.ece) was as good an excuse to do it. Populus/The Times have polled 100 marginal constituencies (seats 51-151) putting both Labour and the Conservatives on 38% of the vote, representing a 6.7% swing to the Tories. The headline focuses on the Tories & Labour being "neck and neck in the marginals" (news of an inevitable victory doesn't sell papers!). However, this actually is pretty much where the Tories need to be in order to get an overall Majority. There are a lot of misconceptions about the national polls and the seats, majorities and hung parliaments that they supposedly translate into, and as someone who has been sad enough to watch the 1979 and 1992 election coverage start to finish (you can see it here if you're interested http://www.youtube.com/user/ajs41) I think it's worth highlighting these.

In particular, the Uniform National Swing (UNS) is the most frequently quoted approach in the Media and accepted by non-professionals. This basically does what it says on the tin: a swing in the survey group is extrapolated uniformly on a nationwide basis for the three main parties, and the rest (SNP etc.) are held constant. The simplicity of this approach is obviously quite attractive, but historically, it has not been a particularly good predictor of the eventual result - most notably in 1979 and 1992. This is a result of several phenomena which have been observed, particularly in relatively close elections. For example, the poster-child of the 1992 election was the "shy Tory" effect, where many voters are embarrassed to say that they will vote Tory as it is distinctly "un-cool" - I note Lily Allen dedicating her "F*** you" song to David Cameron last week.

The second phenomena is the discrepancy between marginal constituencies and core constituencies. As a result of a large amount of funding (usually from the Tories), there is a very large focus upon campaigning in marginal constituencies which tends to increase the swing within them. Indeed, the above Populus/Times poll suggests that this swing is to the tune of about 1.5-2% higher than recent nationwide surveys would suggest. As a result of desperation to "keep the other lot out", the core vote in the incumbent's constituencies also tends to increase, which serves to lower the national average but to no "useful" avail in terms of extra Parliamentary seats.

The third phenomena is the much-hyped "tactical voting" effect, which is harder to pin down. A study of the 1997 election (Impact of Tactical Voting in Recent British Elections. J.E. Curtis et al) suggests that 2% of the Liberal Democrat vote went to Labour and 1% went to the Conservatives - i.e. a 2-1 proportion. It is worth noting that the Liberal Democrats are polling 2-3% lower where they were in 2005 - this effect could be something of a wildcard in this election. Indeed, SNP/PC may play an important part in this. For a much more detailed and extensive discussion of these factors, I highly recommend reading UK Polling Report (http://ukpollingreport.co.uk/blog/) and Political Betting (http://www2.politicalbetting.com/) and in particular its articles on UNS (http://politicalbetting.com/index.php/archives/2010/03/07/andy-cooke-on-the-uns-part-2/ and http://politicalbetting.com/index.php/archives/2010/03/03/andy-cooke-on-the-uns-part-1/) and their seat model (http://politicalbetting.com/index.php/archives/2010/02/25/launching-the-andy-cooke-seats-calculator-final-version/)which takes these effects into account.

But back to the Populus/Times poll.

As a result of boundary changes, notionally, the Conservatives (based upon the 2005 election) will have 214 seats (vs. the 198 they won in 2005). That means that in order to secure an overall majority in the Commons they need to win an additional 112 seats (see http://ukpollingreport.co.uk/guide/conservative-target-seats). The 6.7% swing in this poll suggests that they will get 97 Labour seats, but that does not take into account the Liberal Democrat/SNP etc marginals in which the Tories can also expect to pick up some seats. Unfortunately, there has not been a poll of CON/LDEM constituencies since last summer (it showed a 5.5% swing to the Tories, which would indicate a Tory gain of 21 seats which would provide a clear majority), so until there is a new poll it is difficult to say just how many of these the Tories will pick up. However, even assuming that the Tories do not pick up any of the smaller-party seats (though they do look likely to take Perth & North Perthshire and Angus), in order to take the 15 LDEM seats required to reach the magic number of 326, they would need a swing of 4.25% from the Liberals. Including Perth & North Perthshire and Angus which look like a sure-win for the Tories, the swing required falls to just 3.5% which is not too different from the Liberal Democrat's national performance fall from 2005.

The point I'm trying to make is that the Tories do not actually need to perform that much better than they are currently in order to be sure of a working majority, and in fact, under the current poll results probably already notionally have one. This is in stark contrast to the market's pricing of a hung parliament in GBP and in Gilts.

Of course, all of the above misses probably the "key" issue: the election is as much a choice between Brown and Cameron as individuals as was the 2008 US Election between Obama and McCain, and the 1997 election one between Blair and Major. Faced with five more years of Brown - experience aside - when it comes to that choice at the ballot box, I think the Tories are on for a landslide. There is clear evidence that the Labour party is swinging to the Left, as evidenced by the rise and rise of Ed Balls and the placing of union backers in Labour safe seats (http://www.timesonline.co.uk/tol/news/politics/article7054578.ece). One of the most surprising outcomes of the financial crisis is just how little the political consensus shifted to the Left, globally (the US Healthcare issue is something completely different), and shows that the socialism vs. free market capitalism war was settled a long time ago. Labour looks like it's heading for the political nether-land.

UPDATE: The details of the Populus/Times poll are out (http://populuslimited.com/uploads/download_pdf-070310-The-Times-The-Times-Marginal-Seats-Poll---March-2010.pdf) and page 7 asks the question of LibDem, UKIP etc voters in constituencies where they have no chance of winning and it is clearly a two-horse race between Labour and the Conservatives whether they would vote for Labour or the Conservatives.

13% said they would vote Tory (unchanged from 2005), while 11% said they would vote Labour (down from 12% in 2005). So tactical voting looks as though it will help the Tories more than it will Labour.

1993-redux?

Since the introduction of QE, the level of excess reserves has had a reasonably tight correlation with the level of short-term interest rates (reassuring for the monetarists!). There are reasonable grounds to expect these to rise somewhat, at the margin. Firstly, the recent discount rate hike has removed some of the safety net for the banking system and is likely to be hiked further as part of the normalisation process. Under this assumption, it is reasonable to expect that the current ~$8bn of discount window borrowing will fall as private financing elsewhere starts to appear more attractive.

Secondly, the Treasury recently announced that the Supplementary Financing Programme (SFP) will be reinstated to $200bn. By way of background, this programme was introduced in Autumn 2008 to help the NY Fed regain control of the Effective Fed Funds Rate at a time when the Federal Reserve was undertaking exceptionally large interventions in the financial market (it effectively took the entire interbank funding market onto its balance sheet). In Autumn 2009, the Treasury was running very close to the debt limit at a time when the Administration was trying to steer Healthcare reform through Congress. To avoid introducing further potential Congressional grandstanding, they decided against asking for a formal increase in the debt limit until the Healthcare measure had progressed. Instead, they announced that they would run down the SPF to provide bridge finance which, in effect, put an additional $200bn of excess reserves into the banking system, contributing to the last-gap jump in the Liquidity Trade in November. The re-announcement of the programme represents the reversal of this, as Congress approved an increase in the debt limit back in January.

Now, while neither of these moves represent an explicit tightening of monetary policy under the FOMC's current framework of targeting the Federal Funds Rate (and several FOMC members immediately came out insisting that both moves were not tightening), a $200bn+ reserve drain will inevitably have some form of impact on market rates. The below chart shows Excess Reserves in the banking system (inverse scale - Brown line), the Effective Fed Funds Rate (Green line) and the 12m T-Bill rate (White Line) and, as per above, the brown line is about to turn higher. Many market participants viewed the recent Fed actions as representing a tightening, and many insisted it was not. Interestingly, those that viewed it as a tightening were generally not core-participants in the Rates market, but rather were concentrated in other asset classes. Rates market participants immediately faded the immediate sell-off in the front-end on these moves. So who is "right"? Is this a case of "watch what we do, not what we say"?.

One of the most remarkable observations, with respect to interest rate markets, has been the stability of front-end carry trades following the view that policy rates will be on hold for a very long time. In fact, the best risk-adjusted trade of 2009 was long EDZ9 and, so far, EDZ0 is making a strong claim to the 2010 title itself. This view has been supported by continued dovish rhetoric from central bankers and academics (most notable the Rogoff & Reinhart study that highlights a significant amount of evidence that implies that post-financial crisis recoveries tend to be L-shaped) and suggestions that global output gaps are very wide. All of these points are valid to some extent, but the price action, as well as the outright level of the front-end, is beginning to overprice these issues and it is becoming obvious that the trade is no longer fundamentally-driven and is now a pure momentum-driven trade. I will attempt to show this below.

The below chart shows a forward-looking Taylor Rule estimate using the average economist estimates for core PCE inflation and unemployment. These estimates are consistent with an L-shaped recovery and very gradual fall in the unemployment rate where the size of the output gap exerts downward pressure on core inflation. Under these conditions, the forward Taylor Rule suggests that the policy rate 1yr forward should be -1%. This, of course, does not take into account the effect of QE upon monetary policy. Calculating the impact of QE is obviously exceptionally difficult and, perhaps, somewhat subjective, but several months ago Goldman Sachs did try to do this. By utilising the equivalent easing of their Financial Conditions Index of a 100bps Fed Funds cut, they were able to estimate the quantity of asset purchases that would be consistent with such a move by comparing the QE-effect upon their Financial Conditions Index, coming to the conclusion that this quantity was about $1trn. By the end of Q1, the Fed will have purchased a cumulative $1.75trn, which under the above assumption, can be thought of as roughly equivalent to 175bps of additional easing.

Adding this into the below chart, we can see that the optimal Fed Funds rate 1yr forward should be 0.75% if the assets held on the Fed's balance sheet remain unchanged. This is pretty much where Fed Funds futures are priced, however that does not take into account term premium (which according to back Eurodollars is about 15bps/year), so the equilibrium forward rate should be something like 0.9%. This is somewhat back-of-the-envelope analysis, but it is illustrative that expecting further extension in the front-end is purely dependent upon the growth outlook deteriorating further. Also interesting is the average economist expectation for the path of the Fed Funds rate, which is for it to sit at 1.25% in one year's time. The point here is that the rates market already prices in an L-shaped recovery.

The next thing I want to draw attention to is speculative positioning (see chart below), which now sits at its longest since the CFTC began collating the data in 1995. As market-wide liquidity is lower post-crisis, on a liquidity-adjusted basis, the net-length is effectively larger than it appears. The performance of front-end carry trades has attracted further momentum buying - in particular, since the beginning of March, Open Interest in the front seven contracts has increased by over 160k contracts, or about ~$4m/bp in PV01 terms, with brokers reporting that the price data shows that the majority of this volume has been traded on the offer side of the price, suggesting that the market is increasing its length further.

But it is not only speculators that are playing the carry trade. The steepness of the curve has encouraged Commercial banks to pile into Treasuries, now holding the largest amount on record (see first chart below), with an average duration of about 5.5yrs. Relative to Nominal GDP (second chart below) the holdings are not quite as extreme as they were in 1993, but given bank balance sheets are in much worse state as a result of the current crisis, the effect of losses from a Treasury market sell-off will be far more dramatic. It is also worth noting that the peaks in this ratio in both July 2003 and March 2004 at levels very similar to those at present were respective peaks in the rate market and met with very aggressive sell-offs.

The remaining rates market participants are Bank Swap Desks for whom there are no positioning data, but anecdotally I am led to believe that they also have the carry trade on in significant size. It is worth noting that the swap market is significantly larger than it was in the early-1990s (in 1993, according to ISDA, outstanding Interest Rate Derivatives totalled $8.474trn, while in 2009 they totalled $414trn.). Indeed, from a balance sheet perspective, it is more efficient to express this trade in swaps rather than bonds, so this would suggest that the true size of the carry trade is much larger and that the UST holdings data understates the true size of the carry trade.

So the point I'm trying to get across is that the front-end is over-shooting as a function of momentum (perhaps CTAs are in on the action) and speculators chasing carry-returns. It's an accident waiting to happen.

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.