Update post: UK debt on the brink?

On 2 December 2009 we posted an article with the title: UK debt on the brink? In it we referenced a Morgan Stanley report which hypothesised that the UK’s fiscal crisis may be exacerbated by a political gridlock in 2010. Three months later, markets have begun to price this reality in, with the pound sterling getting hammered across the board accompanied by rising 10-year gilt yields today. We maintain our view that Morgan Stanley was being optimistic in their analysis of what a ‘crisis’ would entail for Britain’s finances and the pound sterling (see “UK debt on the brink?“). We reckon UBS strategists’ recent call for a possible GBP/USD of 1.05 owing to fiscal retrenchment is more likely than a mere 10% decline of the pound sterling. Note we don’t agree with UBS’ reasons given for the possible sterling sell-off, Human Action believes fiscal austerity would be sterling positive. We do, however, agree with UBS strategists and get the sense that confidence is being lost in British policymakers, and once confidence has been let out the box, there’s no way of getting it back – this will be very bearish for the pound sterling and trigger a full-blown fiscal crisis in the UK.

From page 14 of the Morgan Stanley report (embedded below):

“UK fiscal crisis exacerbated by political gridlock. The poor state of government finances is one of the key risks we see in the medium-term. Therefore, one tail risk and potential surprise is that a government bond and FX crisis materializes already in 2010. One candidate for such a scenario is the UK where the upcoming elections could provide a catalyst, particularly if they result in a hung parliament. Such an outcome would likely lead to either a coalition or minority government where the ability to govern effectively will depend on the main party’s ability to forge a consensus view to drive through necessary change.”

Headlines in cyberspace today seem to suggest the sterling fiscal crisis bus may have arrived sooner than expected:

Pound slumps on hung parliament fears

By Russell Lynch, Press Association
Monday, 1 March 2010

The pound hit a nine-month low against the dollar today as fears over a hung parliament sparked a sterling sell-off. The currency fell sharply to as low as 1.478 against the greenback as well as slumping below 1.10 against the euro. Pressure on the pound comes as the Conservatives’ poll lead against Labour narrows – threatening an indecisive general election result when markets want firm action to sort out the UK’s dire public finances.

UK pound drops on hung parliament fears

BBC, 1 March 2010

The pound has tumbled to a 10-month low as fears grow the UK will have a hung parliament in the upcoming election. The currency fell 1.6% to drop below the $1.50 level against the dollar for the first time since May. It has lost 7% against the dollar this year. The pound also fell against the euro and most other major currencies. Separately, the world’s biggest bond fund manager Pimco told the BBC he is concerned about UK government debt unless drastic action is taken.

We still expect the GBP/ZAR will continue to trend lower over the short- to medium-term, until such a time that the SARB decides to forcefully intervene to take the Rand weaker against currencies of its major trading partners (of which Britain is one) toward late 2010 or early 2011.

UK debt on the brink?

We recently posted a piece on the fact that bearish “doomsday” scenarios were not just a view held on the kooky fringe, but were in fact increasingly being factored in to mainstream economic scenarios by some of the big banks and financial institutions.

The latest to join the fray is Morgan Stanley and this time the object of their worries is the UK.  A recent Morgan Stanley report to clients reckons that Britain is not only at risk of outright sovereign default, but that it is likely to be soon.  Like, 2010-soon.  MS highlights the risk that high grade corporate debt could command a lower risk premium (ie lower interest rate) than government debt, a hugely bearish prognosis for the government debt metrics.

It’s funny though.  Once again in typical big-bank-doesn’t-want-to-sound-too-crazy fashion, the consequences don’t really seem to match the prognosis.  What I mean is, MS only reckons that a debt crisis would see “some of the ratings agencies remove the UK’s AAA status”.  The bank also says that an extreme fiscal crisis would lead to “severe” Sterling weakness of, wait for it, 10%!  Wow, scary stuff.  Now I know Sterling has already been hammered in recent times, but in a full-blown debt crisis Sterling will get annihilated by much more than just another 9 pence to the Euro.

In another apocalyptic (not) prediction MS reckon UK bond yields could rise by 150bp.  They should be so lucky.  A debt default situation would probably take longer bond yields toward, if not into, double digits and squeeze the life out of mortgage and long term capital markets.

The capital flight would be huge and it would also send enormous quakes through global financial markets.

One wonders if MS really believes the UK can default in 2010 or whether, like SocGen a few weeks back, they are putting something out to their clients so that at least they can say they covered that base when all goes pear-shaped?

As Human Action said recently regarding the bearish SocGen “scenario”,

“the overall point… is that big banks are seriously considering the not-so-nice outcomes of this global government debt binge.  That the big conservative behind-the-analytical-curve banks are now cottoning probably means that we are closer to a very bearish outcome than many realise.”

You can read the Morgan Stanley piece below.

Morgan Stanley Tougher Times 2010 R1130TD