World Economy

Brexit & $2 Trillion Gilts Market

Brexit & $2 Trillion Gilts MarketBrexit & $2 Trillion Gilts Market

For all that some investors fear Britain leaving the European Union, holders of government debt have barely blinked, with prices near a three-year high last week and foreign investors making record purchases.

By pushing a rise in Bank of England interest rates further into the distance, ‘Brexit’ could be a short-term boost for holders of much of Britain’s $2.1 trillion of government bonds, even if longer-term worries remain, Reuters reported.

Prime Minister David Cameron has agreed outline terms for reforms to the EU which he will put to British voters in a referendum likely to take place in June. Opinion polls have shown a growing lead for the ‘out’ campaign.

If Britain votes to leave, gains should be clearest for holders of bonds due to mature in five years or less, while debt due for repayment in over a decade is more vulnerable to credit rating cuts, longer-term economic malaise and investor unease.

Unlike for company shares or its sterling currency, weaker growth is usually a tonic for British government bonds—dubbed gilts after the gold-edged paper on which they were first printed—as it pushes down inflation and keeps BoE rates low.

Even in the years following the 2008 financial crisis, when Britain’s economy shrank by 6% and sterling lost more than a quarter of its value, gilt prices touched record highs, albeit aided by the BoE’s quantitative easing purchases.

  To Hurt Growth?

Most economists think Brexit would hurt British growth in the short-run—Citi predicts a 4% hit over three years—but this is also likely to delay any rate rise.

“Holding a Brexit referendum, regardless of outcome, will be a drag on growth as businesses delay investment decisions,” said Dave Chappell of Columbia Threadneedle Investments, which manages almost £6 billion ($8.7 billion) of gilts.

Yields on five-year gilts—which move in the opposite direction to prices—touched their lowest in nearly three years on Wednesday. They are likely to drop by 0.15-0.20 percentage points if Britain votes to leave, says J.P. Morgan strategist Francis Diamond.

Recently an economist said that as a small open economy, the removal of trade barriers has probably benefited the UK. Its 2.5% share of world GDP compares with 4% of world exports. Its total trade (exports plus imports) is 59% of GDP, versus the eurozone’s extra-regional 37%, and US’s 31%.

Longer-Term Worries

The picture for longer-dated debt is less rosy due to uncertainty about the terms on which Britain would leave the EU, and how this will affect growth and inflation in the long run.

Foreign investors own more than a quarter of British government bonds, and Britain’s current account deficit is large at 3.7% of GDP. BoE Governor Mark Carney has warned this leaves Britain “dependent on the kindness of strangers”.

A worst-case scenario could see a slide in sterling and a flight of foreign investors. “If the ‘leave’ campaign wins, the safe-haven status of sterling and gilts could be called into question,” Chappell said. “This combination would generate fears around stagflation, causing the yield curve to steepen.”

Most strategists agree ‘Brexit’ would cause long-dated gilts to underperform, but a big sell-off is not their main scenario.

Foreign investors largely stuck with gilts in the run-up to 2014’s referendum on Scottish independence, and bought a record £29.6 billion of them in the last three months of 2015.


Downgrades of Britain’s credit rating in 2013 did little to dent demand. And domestic pension funds, among the biggest holders of gilts, are likely to buy more if yields for long-dated debt rise from recent lows.

The picture could be different if the pound fell by 20%—as mooted in recent notes by Goldman Sachs and Citi—rather than a more modest 5-10%.

“In the event that ‘leave’ wins and you get a sharp depreciation ... to the extent that it starts to lift inflation up towards those 4% levels we had a few years ago, the MPC may have to start to raise rates,” Citi fixed-income strategist Jamie Searle said.

In a worst case scenario, yields on benchmark 10-year gilts could rise as much as a full percentage point compared with US bonds, he added.

Their longer-term prospects would hinge on potentially ill-tempered exit talks slated to last two years.

Most damaging would be if Britain could not secure favorable trade deals with the EU and other countries, hurting long-term growth and also pushing up domestic prices.