Budget 2010: City investors wanted bigger cuts

Alistair Darling failed to reassure investors and credit rating agencies about the country's finances, so traders sent him a clear message: the budget cuts are not big enough. Despite Darling's announcement that Britain will borrow less than expected this year, investors sold UK 10-year bonds, pushing their price lower, and the yield to as high as 3.99% at one stage – above the 3.91% they yielded before the chancellor's speech. Higher yields are perceived negatively as they force governments to pay more to lure investors to buy a country's debt. They are also often used as a benchmark for long-term interest rates, such as mortgages. The UK 10-year bond yield is now higher than Italy's 3.92%, and much higher than the 3.08% offered by rock-solid German bunds. "The last years have taught investors not to take guidance on "intentions" as a guarantee of future action," said Mike Amey, portfolio manager at Pimco, the world's largest bond investor. "Until we have clarity on the full deficit reduction plan we believe that UK bonds remain vulnerable to further bouts of volatility." Pimco's founder Bill Gross recently sent shockwaves through the bond market after saying that UK gilts were "resting on a bed of nitroglycerine" because of the country's ballooning deficit and weak growth. Pimco and other asset managers weren't too impressed by Darling's new forecast of public sector net borrowing of £166.5bn in 2009/10, below a December pre-budget report estimate of £177.6bn. "There's some disappointment there's no further additional tightening," said Neil Williams, chief economist at Hermes Asset Management. "Most of the rabbits in the hat had been pulled by Darling before Christmas, they're offering little over and above that to reassure the gilts market, whose main concern is the longer term debt programme." Bond investors, known as market vigilantes, are pushing governments to cut their multibillion-pound deficits to a level that guarantees their repayment and keeps the highest credit rating possible. A lower rating lifts the cost of debt of a country or a company, as it is perceived to have more risk. Investors have recently speculated about Britain's chances of losing its triple A credit rating, although rating agencies have warned no action will be taken until after the election, depending on how far the budget cuts go. Fitch warned Darling the debt reduction is still short. "While this inches in the right direction in terms of strengthening the medium-term fiscal consolidation path, the deficit reduction path from 2011 is still slow," said Brian Coulton, head of EMEA sovereign ratings at Fitch. The credit agency warned Britain is still "vulnerable to shocks given the uncertainty over the UK's medium-term economic prospects". The country's need to raise about £1bn of debt on each working day still makes some vigilantes nervous, especially after the market's biggest gilt buyer, the Bank of England, recently withdrew its debt-purchasing programme, known as quantitative easing. "There's still an issue of the deficit not being reduced fast enough, it will remain high for the coming financial year, it's more back-loaded than what some would like to see," said Elisabeth Afseth, a credit analyst at Evolution Securities. Sterling fell back sharply against the dollar, hitting a two-week low of $1.4875 before recovering to around $1.4908, down 0.9%. Foreign exchange traders also said Darling's lower forecasts for borrowings and plans to cut the huge deficit were not enough to reassure investors. At the same time the pound was also tracking a weaker euro after news that credit agency Fitch had cut its rating on Portugal's sovereign debt to AA- from AA. Joshua Raymond, market strategist at City Index, said: "Darling missed a key opportunity to reassure investors in the UK of the specific fiscal moves the UK government will take to curb the deficit and put fears of a possible credit rating downgrade from rating agencies to one side." Equity markets were more resilient. Leading stocks were around 10 points lower as Darling stood up but regained some ground to be virtually flat by the time he finished his speech. At the close of trading the FTSE 100 index had edged up 4.25 points to 5677.88, with banks among the main risers, partly on relief there was no immediate announcement of a banking tax.