new gilt coupons and interest rates

[j0hnsmith123]

UK HM Treasury issues new gilts every month or whatever to fulfil borrowing requirements, if investors shunned new gilts (perhaps because they thought the UK is taking on too much debt) thus raising the coupon on the next issue to attract buyers, would UK interest rates be forced up as a consequence?

Is this scenario possible?
Gilts are shunned by investor so coupon rises to 5% while UK interest rates remain around 1%

 

[Martinghoul]

Investor appetite drives bond yields, so if investors were to start shunning gilts, yields would go up. The coupon that's used by the DMO for newly issued gilts is determined by the yield in the mkt at the time of the issue, not the other way round. The way it works is that there's an (almost) universal rule that new bonds have to be issued with prices as close to par as possible. As a result, the higher the mkt yields on the comparator (or WI) bond, the higher the coupon. Hope this helps.

 

[j0hnsmith123]

Thanks for your reply.

So if gilt yields go up this has no bearing on interest rates?

 

[Martinghoul]

Gilt yields ARE market interest rates. What interest rates are you referring to?

 

[j0hnsmith123]

The ones that the BOE MPC set. If HM Treasury has to pay more for borrowing, does this put upward pressure on rates?

I know there's a relationship the other way round (rates rise means yields fall) but I what to know what happens to rates if yields rise significantly.

 

[Martinghoul]

Well, the dynamic gets complicated. On the one hand, the MPC would vehemently deny that what HMT does or does not do influences their rate-setting behavior in any way. They profess that, in matters of monetary policy, they're fiercely independent. Otherwise, they would be perceived to be colluding with HMT to monetize debt, increase inflation and all these bad things. So in that sense there's no link between fiscal and monetary policy (well, apart from Merv's exhortations to fiscal discipline).

On the other hand, if there's trouble in the world of gilts, it is going to have an impact on the economy, inflation expectations, etc, which are all inputs into the MPC decision-making process. In this way, indirectly, interest rates can be affected, indeed.

 

[j0hnsmith123]

Thanks for your comments, food for thought.

I'm thinking that one day in the not too distant future HMT is going to get a surprise at one of the gilt auctions and how I might profit from that (with a low level of risk).

 

[arabianights]

What kind of surprise? One had b/c under 1 in January...

 

[Martinghoul]

Yep, as Arab points out, it would have to be a large surprise, indeed, to shock the HMT/DMO. They're already saying that they wouldn't expect a sov rating downgrade to be a big deal. Maybe, if UK gets downgraded from AAA to junk in one go, that would be a proper surprise, but something tells me that it probably ain't happening.

 

[j0hnsmith123]

I think the UK has too much debt (or will have very soon) and it's ability to pay it back will be called in to question. Thus at some point the market's appetite for more debt will reduce quite drastically so buyers will be hard to find. This could create a snowball.
BBC - Peston's Picks: Recovery risk for government borrowing

 

[Martinghoul]

You're very possibly correct, but the mkt might be anticipating this already, no? Moreover, if push really comes to shove, the Bank of England, let's face it, is a gilt buyer of last resort. Given they can print an unlimited amount of pounds to buy UK govt debt, how does that affect your thinking?

 

[j0hnsmith123]

Yes, maybe it is in the price already - Mar10 sht stg says interest rates will be 1.6% which is quite a long way from the current 0.5%. Whilst a downgrade might be half expected, I suspect the impact would be greater than imagined.

What really seems odd to me is that debt is the problem, so more debt doesn't sound like a convincing solution. The subprime problem was common knowledge and being talked about by people not in financial circles in Jul08, months before the all the fun in Oct08. Now people are talking about debt levels but nothing much has happened yet.

Inflation is a great way to reduce debt but it requires greater money supply, perhaps we will see money printed by HMT.

 

[arabianights]

That isn't a correct interpretation of March short sterling...

 

[j0hnsmith123]

whoops, I thought sht stg tracked base rates, not LIBOR

 

[Martinghoul]

johnsmith, while I agree with certain things you say and, most importantly, your basic premise, some other things you say don't make much sense.

For starters, as Arabian points out, your interpretation of sht stg is wrong. Also, the causality relationship between the base rate and the govt borrowing is not quite as straightforward as you make it look. Finally, the subprime story has completely run its course by early 2008, which is why people outside of finance were talking about it in Jul 08. The late 08 crisis actually had very little to do with subprime, which is why I disagree with your parallel.

As to your last point, agreed, but the money is printed by the Bank of England, not the HMT. So if the Bank of England prints money to buy gilts (as it's doing at the moment), could it happen that gilts don't actually suffer too much?

BTW, this dude (and seems like the IMF) agrees with you, also:
http://www.telegraph.co.uk/finance/...Fiscal-ruin-of-the-Western-world-beckons.html

 

[j0hnsmith123]

Martinghoul, thanks for your comments - I am, as is plainly obvious, far from an expert.

Regarding subprime, I mean that everyone knew there were huge amounts of risky debt on the books as assets and for a good while nothing much happened.

 

[GammaJammer]

I think the DMO comments could well end up being attributed to a lack of media training on the part of Stheeman (DMO) but it did seem a very very odd way to talk at the time. Most market participants' kneejerk reaction was 'what the f**k does that guy know that we don't).

 

[Martinghoul]

I think the DMO comments could well end up being attributed to a lack of media training on the part of Stheeman (DMO) but it did seem a very very odd way to talk at the time. Most market participants' kneejerk reaction was 'what the f**k does that guy know that we don't).

Yep, I have to admit that the thought briefly crossed even my mind, even though I am the furthest thing from a conspiracy theorist. It's a weird thing to say that he probably uttered in all innocence, but, really, as you say, GJ, he should know better.