The Treasury's cost of borrowing has risen by more than a percentage point since March, despite the Bank of England spending £200bn on gilts through its quantitative easing (QE) programme. Experts put the increase down to worries that this and future governments will either prove incapable of reducing their deficit or will resort to inflation in order to erode it. The combined effect has been to catapult UK government bond yields above those of Italy and Spain in the past few weeks alone.

Although the yields on all government bonds have been pushed higher in part as investors divert their money into the fast-rising equity markets, the comparison between the UK and elsewhere shows that British debt has been increasingly shunned since the pre-Budget report at the start of this month, which was widely criticised for failing to unveil a more ambitious deficit reduction plan. With the credit ratings agencies having warned that unless the next Government scales down spending more radically, they are likely to remove Britain's top-tier rating, many suspect 2010 could be the most testing year for government fund-raising in a generation.

Statistics suggest hedge funds have been betting on a possible fiscal crisis, selling more gilts than any other major investor since the Bank's QE programme began, according to Simon Ward of Henderson Global Investors. He said that "other financial institutions", which is dominated by hedge funds and fast-moving dealers, sold some £35bn worth of gilts between April and September. A number of hedge funds, including Crispin Odey's Odey Asset Management, have publicly warned that Britain may be slipping towards a fiscal crisis – something which would push bond yields higher, and send their respective prices tumbling.

However, Tim Besley, a former MPC member, said that the Bank should not be deterred from bringing its QE programme to an end in the coming months by the behaviour of the gilt market.

"It's hard to think that we've got to view this all in terms of the barometer of the gilt market," he said. "It's got to be based on a much broader judgement than that."

He added: "To say that we will still need some form of fiscal tightening in the future is without doubt correct. I view this very much as the beginning of a process that the first budget after the election, I hope by whichever party implements it, will be very much more serious about dealing with the long run issues."

By Edmund Conway

Source >  Telegraph | dec 29