Gilt as the new litmus test of Brexit-related risks - Natixis

René Defossez, Research Analyst at Natixis, suggests that the sharp widening of the spread between the 10-year Gilt and its German counterpart is due exclusively to the increase in the yield of the 10-year Gilt.

Key Quotes

“Yet, in the aftermath of the Brexit referendum, Gilt benefited from both the flight-to-quality and from the Bank of England resurrecting the APF.

Currently, the deficit-to-GDP ratio for the UK is far worse than those of the Eurozone and United States. This ratio could deteriorate next year, whereas elsewhere it could improve. Also, for the first time, because of a divergence in performances, the net debt-to-GBP ratio of the UK could pass some way above the Eurozone ratio. Gilt’s situation could be undermined by the worrying levels reached by the debt and deficit ratios, as well as the current trends for these ratios.

Gilt’s underperformance against the US TNote and Bund is probably but at its start, with this likely to be a recurrent feature for quite some time, as the premiums mentioned above (i.e. inflation, currency and credit risk premiums) may well increase further, unless of course the British government sends clear signals of a change in its Brexit strategy (latest comments by David Davis, notably, suggest not, as the Secretary of State for Exiting the European Union remains convinced that the UK can dictate the terms of its divorce with its European partners...)

The decline of the UK 10-year swap spread obviously proceeds from the same logic, as it is Gilt’s quality that explains why this spread has swung back into negative territory, where it is likely to stay for quite some time.

The last matter of concern is that the poor fiscal performances are due largely to disappointing tax receipts. Taxation is a good proxy of economic activity. One can easily imagine a negative spiral taking hold: slowdown in activity could contribute to a deterioration in the fiscal situation, in turn driving up sovereign bond yields, in turn holding back growth. Furthermore, the deterioration in the UK’s fiscal situation would prevent the government from implementing counter-cyclical measures and, in a worst-case scenario, could even force it to take pro-cyclical measures.”