Sterling May Suffer As Foreign Investors Shun Gilts

 
   By Keith Jenkins 
   Of DOW JONES NEWSWIRES 
 

LONDON (Dow Jones)--Concerns are growing that the pound could come under further pressure as foreign investors shun U.K. gilts on fears of a sharp increase in government borrowing.

The U.K. government's plans to stabilize the nation's ailing banking industry and the potential need for a fiscal stimulus package to revitalize a struggling economy will lead to higher borrowing in the shape of gilts issuance.

Moreover, there are concerns that the cost of that borrowing may be higher than previously anticipated as foreign investors desert the gilt market.

According to Simon Derrick, an analyst at Bank of New York Mellon, there have been extremely heavy flows of foreign capital out of U.K. fixed-income instruments since mid-September.

This would seem to indicate a fundamental shift in what investors are concerned about, said Derrick. "If the majority of the concerns for sterling over the past 15 months were driven by specific worries over the outlook for the economy, it seems that over the past two months the focus has shifted to how government support for the economy will be paid for," he said.

"This shift is entirely understandable given the increased scarcity of pools of international capital that the government may previously have hoped to draw upon," Derrick added.

So far, the U.K. Debt Management Office's additional auctions have attracted strong demand. However, this has been due principally to domestic demand.

Jason Simpson, market strategist at Royal Bank of Scotland, said domestic buyers are unlikely to shun gilts while the fundamental backdrop remains positive for fixed-income markets.

He added that inflation is likely to fall in the months ahead and interest rates are expected to continue to decline further following the Bank of England's 150 basis point rate cut last week.

According to the Sonia market, the BOE's Bank Rate is likely to fall by another 50bps to 2.50% in December, and to drop to 2.0% by the March Monetary Policy Committee meeting.

"The recent gilt auctions have gone well, with heavy sponsorship from the domestic market," Simpson added.

However, this may not continue indefinitely.

Analysts at Royal Bank of Canada noted Tuesday that the current slew of U.K. supply and abundance of different auctions for investors to choose from can present a real hurdle to the success of gilt issuance.

Moreover, Tuesday's auction of GBP3.5 billion of 4.75% September 2015 Treasury bonds was only modestly successful.

The auction attracted a bid-to-cover ratio of 1.53, the U.K. Debt Management Office said. That ratio, a gauge of demand, was below the 2.39 reported at the previous auction of the issue on Oct. 28 2004, while the yield "tail", or difference between the average and highest yields, a gauge of demand, was 2.1 basis points, using unrounded yields.

In the foreign exchanges, sterling was trading at $1.5558 at 1115 GMT, down from $1.5631 in late New York business Monday and from just above $2.00 in July.

It was also weak against the euro, which hit a new high at GBP 0.8213 Tuesday, its highest since the introduction of the single currency, before easing marginally to 0.8182.

The U.K. prime minister, Gordon Brown, again made it clear Tuesday that the government would be using fiscal policy to boost the economy. But he stopped short of clarifying whether that would include unfunded tax cuts.

-By Keith Jenkins, Dow Jones Newswires; +44-20-7842-9495; keith.jenkins@dowjones.com

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(END) Dow Jones Newswires

November 11, 2008 06:33 ET (11:33 GMT)


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