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The swing towards Scottish independence in some opinion polls has sparked stories of investors pulling their cash from potentially affected assets and hurried calculations about how high the UK’s debt burden might go if an independent Scotland eschews its share of national debt. So why are UK government bonds, or gilts, not showing more signs of a sell-off?
Although the pound fell to a 10-month low against the US dollar on Monday, UK government borrowing costs remain far lower than they were at the start of the year and the cost of insuring UK debt against default has remained largely unchanged over the past month, according to data group Markit.
It seems particularly strange given stories that prices for Spanish government bonds are plunging on fears that Scottish independence might boost an independence movement in Catalonia.
However, with the UK’s outstanding stock of gilts at a record high of more than £1tn and foreign investors already net sellers of gilts this year, analysts say the UK cannot yet write off the prospect of higher borrowing costs as a result of the referendum.
What has been happening to gilts?
Up until this week, investors in gilts appeared largely unfazed by the chatter around Scottish independence.
With the publication of a poll at the weekend showing nationalist campaigners in the lead, things changed.
When bond prices fall, yields rise, and the yield on the UK’s benchmark 10-year bonds has increased from 2.37 per cent at the end of August to 2.5 per cent today.
At the shorter end of the bond market there has also been change – although things are moving the other way.
Prices rose for two-year gilts, pushing down the yield from 0.86 per cent at the end of last week to 0.77 per cent on Monday. Bankers say this is because short-term government bond yields tend to be more affected by interest rate expectations, reflecting the idea that Scottish independence could leave the Bank of England less willing to raise interest rates in the near future.
However, these movements need to be put into context. Ten-year gilt yields are no higher than they were at the beginning of August. According to one analyst, the changes are not particularly unusual for any given week.
Why have UK borrowing costs not increased more?
You cannot think about UK government bond prices without considering what is happening to other government borrowing costs. The long period of low interest rates resulting from the financial crisis have sent yields falling across the US, Europe and emerging markets in recent years.
Some say the UK gilt market has enjoyed a near 30-year rally, dating back to the 1980s when yields were more than 12 per cent.
Expectations that the Bank of England might be the first major central bank to raise interest rates post-crisis had led some investors to expect the rally to come to an end this year, yet prices have kept on rising and yields falling.
The yield on benchmark 10-year gilts may have increased in the past two days but it started the year at more than 3 per cent and is now at 2.5 per cent.
Scotland is one of a number of factors that gilt investors bear in mind, said Sam Hill, senior UK economist at RBC Capital Markets. Geopolitical tension, broader economic data in the UK, the plans for the US to curb its bond-buying programme and the lack of inflation in the EU are all being taken into consideration right now.
Another reason gilts may be moving at a slower pace than sterling is that debt and currency can attract investors with different priorities. More than a quarter of gilts are held by the Bank of England and a further quarter by pension funds and insurance companies, who invest for the long term. By contrast, currency investors are reacting more to short-term expectations of interest rate movements.
What might happen if Scotland votes Yes?
Expectations fall broadly into two camps. On one side are those who think the UK’s position as a borrower will be damaged by the loss of Scotland and that markets will react badly to the uncertainty. They believe investors will demand greater compensations for the perceived risks of holding UK debt and that yields will rise.
On the other side are those who say the subsequent economic uncertainty of a Yes victory will push back the Bank of England’s plans to raise interest rates, and so keep gilt yields down.
Any dip in business confidence and volatility in the equity markets could also benefit gilt investors, says Justin Knight, head of European rates strategy at UBS. Turbulence in equity markets in particular could encourage a flight to the safety of government bonds, helping to keep prices up and yields down.
And there is comfort to be gained from the fact that the Treasury has said it will honour UK sovereign bonds no matter what happens, and that even if Scotland does refuse to take a share of national debt the increase in the UK’s net debt to GDP ratio (estimated to increase from 89 per cent to almost 100 per cent) will remain lower than those of other European countries, which are borrowing at sub-2.5 per cent rates.
What if there is a No vote?
If Scotland votes No then the Bank of England may well be the first major central bank to raise interest rates, as has been widely predicted in the past. Fixed-income analysts say UK gilts have already decoupled from European government bonds, which are being driven by the expectation that the European Central Bank will have to keep interest rates low and might start a programme of quantitative easing in the face of poor economic growth.
However, if the vote is narrow it could slow down the rate hike cycle, depending on the broader economic environment, and this may keep the UK’s borrowing costs down. There is also the possibility that investors might be concerned that the issue of Scottish independence will be revisited in the future and that this uncertainty could create volatility in the gilt market.