The brutal truth

UK gilts: The UK sounds Greek again. Britain’s new government is finding skeletons in the fiscal cupboard. George Osborne, the incoming chancellor of the exchequer, is appointing an independent watchdog to check the numbers out. The gilt market perhaps ought to recoil at the revelation that things are even worse than thought. But it’s more likely to look on the bright side: coalition honeymoon, transparency and rectitude to come.

UK government bonds will for now probably continue defying threats that kill in the Aegean. A record peacetime deficit, an inflation rate of 3.4 per cent, a plunging pound: no matter, UK 10-year paper has risen in value by about 2 per cent this year and yields a miserly 3.8 per cent. But while Osborne's deficit-cutting commitment will reassure, the medium-term risks to gilts remain great.

Gilts’ appeal is largely relative. UK debt levels have worsened appallingly — but are not yet appaling. Britain, like the United States, is rightly judged to have a more adaptable economy than the euro zone’s. The pound can weaken, helping competitiveness and growth and therefore favouring rebalancing of the government's accounts. But the growth that can save is not strongly in evidence now. Mervyn King, the Bank of England governor, has warned of possible growth disappointment as fiscal cuts kick in. Ironically this is another factor supporting gilts. Inflation is up, but is expected to be dragged down by economic weakness. That means interest rates will probably remain low, favouring bonds.

Still, gilts investors cannot be complacent. The fiscal deficit is huge but money-printing — quantitative easing — exceeded it in the year to March. Spencer Dale, the BoE’s chief economist, speculated last week that QE had taken about one percentage point off gilt yields. Unless the economy worsens, the BoE is unlikely to resume gilt purchases. And one day it must start selling its gilt mountain.

There are other big risks. The coalition honeymooners may fall out. The economic turnaround will be extremely hard to generate. And Osborne’s fiscal surgery may half kill the patient. For a UK that has much to do to stop its debt spiralling, gilt returns look poor. But the remarkable bonds may smile through the honeymoon all the same.