‘Magic money tree’ offers sour fruit for bondholders

The “magic money tree” is in full bloom. This image has been commonly used by Conservative politicians in the UK to describe how their Labour rivals would fund fiscal policies. But now the major parties are falling over each other to announce generous spending packages, for the National Health Service, schools, the police and infrastructure projects.

Is this because austerity succeeded and the nation’s finances are back in good health? Hardly. The government has managed to stabilise the level of debt as a percentage of gross domestic product by reducing the annual deficit. But the trajectory for government debt looks bleak given the fiscal demands of an ageing population.

Why then are even Conservative politicians suddenly relaxed about the level of debt? In a recent speech, the chancellor Sajid Javid gave us the answer when he said that “with interest rates where they are today it makes sense to borrow and spend the money”. With higher debt not accompanied by punishingly high interest rates, the temptations to borrow more are too great.

These low interest rates are thanks in large part to the Bank of England and its global peers. Almost as fast as the Debt Management Office has been issuing debt, the Bank of England has been buying it. The £600bn of government bonds bought under the BoE’s asset purchase programme amounts to about 38 per cent of the gilt issuance over the period. Similarly, the European Central Bank has absorbed about a third of German Bunds issued since 2015.

This now looks like a permanent gift from the central banks. The Federal Reserve tried for a while to shrink its balance sheet but has given up. The BoE never even tried and the ECB is still buying bonds. All have committed to keeping policy rates low, and perhaps to cut them even further.

Of course the central banks have not set out to bail out governments. They have merely been doing their job of trying to meet their inflation targets. If inflation remains absent, this would suggest there is still a large amount of spare capacity in these economies and a combined push from both monetary and fiscal policy is economically sensible. Governments can keep spending, debt can keep rising and central banks can keep interest rates low.

But if there is not spare capacity in the economy then inflation will show up and we have a problem. The fiscal expansion we are looking at is sizeable. The chancellor’s spending review delivered in September already announced a £14bn increase in the 2021 fiscal year.

This is a 4.1 per cent real increase in day-to-day government spending, and is more than half a per cent of GDP. On top of this, the Conservative manifesto commits to an additional £20bn per year for infrastructure. The Labour manifesto boasts even higher spending across all departments, and an increase by as much as £55bn per year for infrastructure.

Some of this additional spending will go towards public sector recruitment and pay. The Conservative party has pledged 20,000 more police officers, 50,000 more nurses and 6,000 more doctors. The Labour party has committed to an immediate 5 per cent increase in public sector pay and above-inflation increases for the remainder of the parliament.

It is not just public sector pay. Both major parties have ambitious plans for the national living wage. Labour plans to increase it immediately from £8.21 to £10. The Conservatives plan to raise it to £10.50 by 2024. About 7 per cent of workers are on the “national living wage” but such an increase would capture a much broader section of the workforce, perhaps as much as a quarter of total private employment.

Yet there is little talk of the inflationary implications of these policies. Perhaps the market, like BoE governor Mark Carney, is preoccupied with external risks. In a recent speech titled “Sea change”, he argued that the risks facing the UK economy had shifted decisively to the downside due to global factors.

I agree with Mr Carney that a sea change is coming, but I am looking at a different ocean. Put simply, it was hard for the BoE to encourage inflation when about a fifth of the total workforce was on a pay freeze. On the parties’ suggested trajectory, it won’t be.

Assuming that a no-deal Brexit is now off the table, I struggle to see how the economy will absorb these spending policies without some acceleration in inflation in the coming years. If correct, this will prove disappointing for those who have bought gilts at recent nominal lows.

A repricing of short-term policy rates could see 10-year bond yields move back above 1 per cent. If domestic pressures coincide with a resolution of global tensions, then the move could be more significant than that. It would not be bad for the full range of sterling markets, since higher pay should feed into higher consumer spending — which in turn could increase the appeal of domestically focused UK stocks.

No one will be more disappointed by a hawkish shift at the BoE than the government. The next chancellor would do well to remember that what the bank giveth, it can take away. It may not, after all, prove so cheap to fund all this additional spending that the electorate has been promised.

Karen Ward is chief market strategist for Emea at JPMorgan Asset Management