The yield on 10-year gilts spiked Wednesday to 3.97pc, 46 basis points higher than costs on French bonds. Britain and France were neck and neck as recently as last month, before Labour’s pre-Budget report raised deep concerns among Chinese, Arab, and Russian investors about the credibility of British state.
But what has caught market attention is the narrowing gap with Italian bonds, once mocked as the symbol of an ill-governed nation in thrall to the Dolce Vita.
Yields on 10-Italian treasuries have been hovering just above 4pc despite the eurozone’s Greek crisis, dropping as low as 3.98pc earlier this week.
Julian Callow, Europe economist at Barclays Capital, said Britain is nearing the eye of the storm as the Bank of England starts to unwind quantitative easing.
“The Bank has bought more gilts over the last nine months than the Government has issued. It has magically eradicated the cost of financing the deficits, but this is going twist dramatically the other way in early 2010. Markets know this. They are demanding a risk premium on sterling.”
“On top of this you have all the uncertainty over the election. We have the highest deficit in the EU as a share of GDP after Latvia and Ireland. It is not clear whether the next government will have the nerve to push through the tremendous fiscal tightening we need,” he said.
Britain is vulnerable to a “gilts strike” because foreign investors own £217bn of UK debt, or 28pc of the total. These are footloose funds and likely to sell large holdings if Britain loses its AAA rating.
They have other tempting places to park their money, such as Turkey, Brazil, or India, where demography is healthy and growth prospects are better. Chile has already undercut British debt yields on some maturities.
Simon Derrick, currency chief at the Bank of New York Mellon, said global markets are unimpressed by the pre-Budget report and do not believe the UK Treasury forecast for 3.5pc growth in 2011.
“The Government will have borrowed an extra £700bn by 2014. And the national debt will reach £1.5 trillion, which is equal £48,000 per head of the working population. The market response is entirely rational,” he said
Italy has its own problems, of course. Public debt was much higher before the crisis began. The IMF expects it to reach 120pc of GDP next year. However, this debt is mostly owned by high-saving Italians, who are less fickle than foreign funds.
Italy’s household debt was 34pc of GDP in 2007, compared to 100pc in the UK. “If you look at private and public debt together, they are in better shape,” said Marc Ostwald from Monument Securities.
“Unless our Government gets a grip soon were going to see Gilt spreads widen to 120 basis points over Bunds, with the risk of 150 if there is no clear winner in the election,” he said.
For Italy, this may just be the calm before the storm. Markets assume that Germany will ultimately bail out Greece if necessary, preventing contagion to the rest of the Club Med bloc.
This is a questionable judgement. Volker Wissing, head of the finance committee of the German Bundestag, said it must be made explicit that “Germany will not take responsibility for Greek debts”.
Mr Wissing said that ex-finance minister Peer Steinbruck was speaking for himself – not for the German state – when he hinted at rescues for eurozone laggards. His comments should be repudiated.