Macro Overview 2

18/05/26 – 25/05/26

What to do about the internationalisation of the British gilt market :

Parallel to last weeks analysis, this week we will turn our focus back to the UK gilt market. Over the past decade there has been a mass internationalisation of British bonds. A lack of incentives for domestic investors to invest in British gilts, alongside an outpouring of capital into more attractive markets like the US has meant that one third of gilt investors today are foreign (FT). Statistically it is true that emotionally attached British investors are more likely to hold onto domestic bonds, even in times of hardship, reducing frequent fluctuations in UK borrowing costs. In contrast foreign institutional investors (predominantly hedge funds) are far more likely to sell-off at the slightest sign of instability given their relentless quest for profit. Indeed, last week’s disproportionately large sell-off following pressure on Starmer to exit, and the subsequent hike in UK borrowing costs epitomises this problem. It is clear the gilt market has become a lot less ‘sticky’ given the rise in foreign involvement and apathetic approach of British investors. Yet it would appear our government (past and present) has done very little to combat this.  

In fact it has gotten progressively worse over the past two decades. Firstly the slow collapse of the defined benefit pension scheme (a scheme where retirees are paid a fixed income every year during retirement) has limited the need for certain pension funds to hold capital in stable, fixed-income-paying assets like bonds. There has also been a major pivot from quantitative easing to quantitative tightening over the past 4 years, meaning a rise in both passive QT (allowing bonds to mature without replacing them) and active QT (the central bank selling gilts back to the open market). This has left a huge gap in the gilt market previously filled by the central bank, which has prompted the UK to offer higher rates to attract new buyers for leftover bonds. These gaps are then naturally filled by a huge portion of international investors as UK pension funds and banks cannot afford to fill in the mountain of bonds left by the central bank. Careful now, I am not at all saying that we should reinstate the defined benefit pension scheme or increase QE purely to drive out international gilt investors. That would be rather silly. I am simply explaining what has been partial in causing the progressive internationalisation of the gilt market. So what can we do about it?

One potential solution to boost domestic investment in the UK gilt market is to ease certain capital constraints on UK banks. Current regulations force banks to set aside huge capital buffers against ‘risks’ on their balance sheets, which creates a high opportunity cost for banks looking to purchase large amounts of British debt. Quite simply then, regulators could look to reduce the amount of cash that banks are forced to hold against UK bonds. Barclays have recently told the FT that a dilution of said regulations could increase demand for bonds by £150bn and in turn lower borrowing costs by £2.5bn a year. However, as appealing as this sounds, one must consider the downside. Reducing the risk-weight of bonds artificially increases banks’ capital ratio, which masks the true risks on their balance sheets and enables them to issue more loans without needing as much cash. Moreover artificially inflated capital ratios would likely cause credit ratings agencies to adjust UK banks’ ratings downward, raising their internal cost of capital as investors now demand a premium to borrow loans from them. If implemented the policy could also limit future foreign investment (FDI) into the UK, as it may signal to foreign investors that global markets have such little confidence in the UK that we must manipulate banking laws to boost domestic demand.

As such perhaps a middle-ground might be found in limiting the leverage ratio exemption to a fixed percentage of the bank’s total capital (ie you only get cash-relief on bonds if they are less than 5% of total assets), which would cap the amount a bank could inflate its capital ratio. Alternatively banks could also begin to publish two sets of capital ratios in their disclosures: one with the gilt exemption, and one without it. However if no middle-ground can be found by our friends at the FCA then there seems to be nothing wrong with the proposed policy inducements through the tax system or via other forms of sweetener. Indeed ‘If all else fails, offer a carrot’. But I think that’s enough of gilts this week, and next. At least until the next borrowing crisis.