Could UK gilts plunge to zero? It’s a question growing numbers of clients have been asking us with bonds totalling $17trn now priced with negative yields amid global fears of deflation. 
Given the serious challenges facing the UK, it is certainly reasonable to harbour concerns about how these might manifest themselves in the government bond market. However, we do not see rates heading to zero, for a number of reasons.
Key among these is that the main UK economic institutions are very alive to the dangers of negative rates. It is now five years since European government bond markets started to trade with negative yields. Whilst the Bank of England was quick to cut base rates to 0.5 per cent a decade ago, it has seen that negative yields are no silver bullet to economic stimulus. Eurozone growth outstripped the UK’s in 2017, but it has since slipped and now mirrors that of angst-ridden Brexit Britain.
Moreover, Mark Carney sees that negative yields aren’t likely to help. It’s not just that UK clearers’ IT departments might struggle to put a negative sign in front of a number; there is also an understanding that negative rates may well be robbing Peter to pay Paul. For example, lower gilt yields for pension funds will mean increased funding gaps for many of them. That gap is assessed triennially, and the larger the gap the more companies will be required to buy more bonds or other lower-risk assets. Put simply, companies will be forced to deploy money into pension assets rather than into the pot for “real” investments.
Savers, of course, would see meagre deposit rates evaporate. As we have witnessed in Japan, those who save – pensioners for example – don’t suddenly spend their savings because returns are zero; quite the opposite. Zero rates encourage more saving as expectations that incomes will vanish fuel the desire for a larger pot of money. It is a logical response but not one that sits well with idea of current monetary policy. If lower rates do not encourage cash into riskier assets (i.e. investment), a key plank for lower rates is removed. For Europe, we are about to discover what negative rates really mean. To date, depositors have been shielded from the full horror of deposits at -0.5 per cent. That is finally about to change as banks such as Deutsche Bank look to pass on European Central Bank policy rates rather than protect customers from negative rates as they have done since 2015.
Why would the UK be different? To date, there are structural reasons why negative rates are less likely. Pure demographics are supportive with the UK’s population increasing by 15 per cent since 2000 as opposed to a mere 2.5 per cent in Germany. Inflation remains higher (pushing up gilt yields) than in the eurozone, albeit a main driver of that has been the weak sterling. Indeed, as important as anything remains the free-floating currency. Whilst sterling at its current lows doesn’t look pretty, it ensures flexibility and is supported by the independent single, unitary, central banking authority that manages monetary policy.
None of this, of course, means gilts are headed to the heady heights of 1.7 per cent (where we were this time last year) any time soon. Structurally, G7 rates markets remain lower than domestic inflation which gives some idea of the market’s expectation of future inflation. The International Monetary Fund has also lowered global growth forecast to 3 per cent adding to the ongoing expectation of continued low rates.
It may seem like a competitive advantage to fund in global financial markets at negative interest rates, as in Germany, but it is not quite so simple. It is not unreasonable to expect a return on investment and negative yields point to stresses in the system and shrinking growth expectations. As Britain seeks to leave Europe’s political orbit, it would do well to not let its bond market become rooted in the world of negative interest rates.
Adrian Hull is head of fixed income at Kames Capital. The views expressed above are his own and should not be taken as investment advice.