The City doesn’t trust Merkozy’s Europe
I was on my way to my office in the City of London last Friday morning when I realised that Cameron had taken a big decision in Europe. When you are dealing on a trading desk you try to guess the effect of these political decisions on the financial assets more directly related to it and affected by it. And believe me, in the last couple of years this has been a constant challenge for us bond traders.
Cameron’s was a big move, a big decision, a brave answer to Europe or a cowardly one depending on the point of view taken. We all knew that the trend of euro scepticism in Britain and especially within the City had been gathering pace over the last number of months. Thus, could we not say that Cameron in the end was just expressing the thoughts of the City? I believe so. The City is the jewel of the British economy. We can quantify the macro numbers of the City within the British economy. However it is not just that, it is also the know-how, the talent from all over the world, the pioneering new financial trends and the visibility that the City offers to the UK. These qualitative factors have to be seriously taken into account to understand the true importance of this financial hub.
And then we, professionals here in London, can feel increasing pressure from Frankfurt and Paris to diminish the importance of the City. Hence, the first and most visceral reactions from the City on Friday morning were those of joy and relief. Joy because of Cameron’s strong defence of the square mile and relief for gaining distance from the plans to save the troubled euro. The markets were showing this with the 10 year gilt (10 year UK government bonds) slightly improving against the bund. This moderate move might not seem important but it was crucial for us traders to see strength in the market after Cameron’s decision. To understand this better: could you imagine the effect on lets say the Italian 10 year BTPS (10 year Italian government bonds) if Monti would have said no to Sarkozy and Merkel? Although no one knows the reaction of the market, I have a very strong feeling that the Italian bond would probably have sent its yield to the moon and the price to hell. In other words, it would have lost much of its value, something that did not happen to the gilt last Friday.
Furthermore we have been seeing that institutional investors have been buying gilts as a “safe harbour” whilst the European debt crisis was unfolding. As a consequence of this, the yield of the gilt has dramatically dropped by half, from yielding 3.88% in February 2011 to just 2.12% now and with the spread with Germany almost flat. This means that the cost of funding for Germany and the UK is the same at the moment. I took the liberty to put safe harbour between quotation marks because knowing that the growth of Britain is 0.5%, with forecasts to contract in the next few quarters, the budget deficit at -10.30% of GDP, debt to GDP is 79.80% and inflation at 5% courtesy of the quantitative easing (QE), one could reasonably doubt the safety of this harbour.
However regardless if the macroeconomic data of Britain is better or worse than those of two countries harshly treated by the markets like Italy and Spain, in the end markets are not only about financial data, but also about perceptions. If the market has the perception for the UK gilt as being much safer than the Spanish bono or the Italian BTPS the money simply goes there and buys gilts. The question now is to see whether after Cameron’s decision this trend to invest in gilts will continue or not. I think it shall continue because if we assume that one reason for this flight to quality is the perception of security in a City-led British economy, certainly another reason is the diversification for investors when buying sterling denominated bonds. Thus now that the UK is less involved in Europe, this sense of diversification when buying gilts is even stronger.
In an opinion article that I wrote for an Spanish economic newspaper last November I said that “la City no cree en el euro” (the City does not believe in the euro) and now after Cameron’s decision expressing that idea I would go further and say that the City neither believes in the euro nor in a Europe led by Merkel and Sarkozy.
Economist and bond trader at King Shaxson in London