Weaker still and weaker

The downgrade of British sovereign debt by Moody’s did not spook the markets. But investors were already worried

“We will safeguard Britain’s credit rating with a credible plan to eliminate the bulk of the structural deficit over a parliament,” read the 2010 Conservative manifesto. Well, so much for that. The decision by Moody’s, one of the three big rating agencies, to downgrade Britain from Aaa to Aa1 on February 22nd was a colossal embarrassment. Moody’s now ranks Britain’s credit lower than that of Luxembourgor the Isle of Man.

It is hard to spot an immediate impact in Britain, either. Investors had expected the ratings agencies to act after last year’s autumn statement revealed that the government was struggling to reduce its deficit on schedule. The two other big ratings agencies—Fitch and Standard and Poor’s—both have Britain on “negative watch”.Sterling dropped to a 32-month low against the dollar and reached its weakest level against the euro since October 2011, but gilt yields actually fell.

Pull back a little, though, and the picture is more worrying. So far the pound is the weakest major currency of 2013. It has fallen even farther than the yen, where the decline had the explicit backing of the Japanese prime minister. In the past few weeks gilt yields have been rising relative to the cost of borrowing of the German government, too.

Several things are making investors wary of British assets. As Moody’s noted in justifying its downgrade, the performance of the economy has been poor; figures released on February 27th showed that GDP had shrunk by 0.3% in the fourth quarter of 2012 and is still 3% smaller than it was in the first quarter of 2008. Growth forecasts for the next few years were lowered in the autumn statement.

A fall in the pound makes Britain’s goods cheaper for foreign buyers—a welcome tonic for exporters at a time when the current-account deficit is running at 3.5% of GDP. But sterling’s big decline in 2008 and 2009 did not cut the trade deficit. The downside of a weaker pound is that the price of imported goods, such as oil, will increase, further squeezing consumer spending. “It’s not just that our gilt outlook is weak; it’s not just that we’ve lost our triple-A credit rating; it’s that we’re really addicted to imported goods” says Jim Leaviss of M and G, a fund-management group. “A current-account deficit this large has historically preceded a sterling crisis.”

Higher import prices are also likely to ensure that the Bank of England continues to overshoot its 2% inflation target, as it has for the last 38 months. Indeed, the bank recently predicted inflation would stay above the target for the next two years. Despite this, three members of the nine-strong monetary-policy committee—including the governor, Sir Mervyn King—recently voted for more quantitative easing.

With ten-year gilts yielding just 2%, domestic investors seem likely to lose money in real terms. Foreign investors might not be too keen to buy such a low-yielding asset in a depreciating currency. If Britain’s borrowing costs rise sharply, the government’s deficit-cutting task will be made even harder. However, this yield rise could be offset if the Bank buys more gilts in a further extension of QE.

The good news is that the foreign exchange and government bond markets are an ugly contest these days, in which few options look attractive. The indecisive Italian election result reawakened investor fears about the stability of the euro zone, and may make gilts appear relatively safe, as was the case in 2011 and 2012. Both Japan and America could loosen their monetary policy further, an approach that may put pressure on their currencies. Britain is not the only country with problems.