Bulls should prepare for a 'crushing blow'

Following the financial crisis, governments have effectively taken on the banking sector's debt load. Now the markets have begun to worry about their solvency. Britain is in the spotlight after a Pre-Budget Report (PBR) that simply postponed the "really tough decisions" until after next year's general election, says HSBC's Stephen King in The Independent.

The medium-term danger is that investors become increasingly worried about Britain's finances, and so begin to demand higher interest rates for holding its debt. Because gilt yields determine long-term borrowing costs, higher yields (as bond prices fall) would squeeze the economy and scupper any recovery.

Markets are already getting jumpy as the PBR left us "none the wiser" about how the government would cut the deficit, says Capital Economics. The yield on ten-year gilts jumped by 0.15% the day after the speech, one of the steepest rises this year. Credit ratings agencies have indicated that they won't take away Britain's AAA-credit rating before the election. But putting off major measures until after the vote makes investors more nervous about the prospect of a hung parliament. Getting a coalition to agree on how to slash debt wouldn't be easy.

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Another problem is that the growth forecasts behind the borrowing estimates look questionable. Before the credit crisis, household consumption contributed 1.75% and business investment 0.25% to annual growth, says Nick Parsons of NabCapital. Now the Treasury hopes they will provide a respective 2% and 1% in 2011 and 2012. That's a "massive gamble on growth". Yet given "tight family finances and rising joblessness, there's still no indication of where it's going to come from".

Gilt yields have also been artificially propped up by the Bank of England's quantitative easing programme, says Ian King in The Times. The bank holds around a third of the gilt market. But this is to be wound down next year, just as £174bn of gilts are "unloaded on the market" like "geese being force-fed foie gras". That's a "frightening prospect". A "marked rise in inflation in the coming months" is also a threat to gilts, says Michael Saunders of Citigroup. No wonder Morgan Stanley reckons that a "fiscal crisis" after a hung parliament, with a "severe" sell-off in gilts and sterling, is a potential shock for 2010.