Ask most people in the UK about the euro and you are likely to get a sceptical response. The majority is still against joining the single currency and few investors are yet making serious preparations for a sterling entry.
We think this is too risky. Our view is that the euro is going to be the largest political issue of the next two years and that this could have a significant impact on UK financial markets. Moreover, we believe that the prospects of sterling entering EMU are much higher than many investors realise and that the implications of such an entry on the UK bond market would be enormous. Overnight, the investible local currency bond universe for UK pension funds would grow from e611bn to e4,460bn, a sevenfold increase. The management of UK pensions bond portfolios would be transformed from that of investing in the relatively small, idiosyncratic sterling bond market to being part of the second largest bond market in the world. UK investors, therefore, need to start thinking about what possible Emu entry will mean for the management of their fixed interest assets.
To begin with, it will be useful to see how soon sterling might join the euro. The first point is that it is clear that the current Labour administration is keen to join. Prime minister Tony Blair has spelled out his party’s commitment in principle to joining, with Chancellor Gordon Brown laying down the criteria for entry. It is also clear, however, that Blair will not risk losing the next election on an all-out pro-euro campaign. For the Conservatives, conversely, it is probably their only chance of winning the election. It will therefore be a key part of the election debate, even if the Labour Party tries to play it down.
The election is now almost certainly not that far away. The accepted wisdom among political commentators is that the general election will be in May this year less than three months away, so long as Labour retain a healthy lead in the polls into the spring. Blair is very likely to be re-elected, albeit with a reduced majority. He has made it clear that any referendum will be within two years of an election victory. This would give him the best chance of winning as it would come during his post-election honeymoon period. He will not risk delaying it until the mid-term doldrums set in. The referendum is likely to be held, therefore, as early as October 2001.
Even if the general election were delayed, the latest likely date for the referendum would be October 2002. Assuming that the referendum result is a “Yes” then the sterling exchange rate could be irreversibly fixed to the euro as early as the end of next year.
Now the key assumption here is that the referendum will be passed. Surely, many will argue, the British people are too sceptical to say “Yes”. This may be true but it would be unwise to underestimate the degree that governments can influence their electorates. Studies of referenda worldwide have shown that people generally follow their government’s recommendation. In 1975 early polls in the UK showed a clear majority against EU entry which was overturned once the government started campaigning vigorously in its favour. The economic argument will look more persuasive now that Brown’s five tests (woolly though they are) have largely been met. The Conservatives are unlikely to be able to mount a credible opposition, newly defeated and divided on the subject as they would be. Even if the vote is negative the government may just choose to keep going back, as has been the case in Denmark.
This is not to say that the results of the general election or the referendum are foregone conclusions. But it does suggest to us that the issue of euro entry will dominate UK markets over the next two years and that the chances of entry are much higher than generally held.
Let us assume that sterling does go in. What would it mean for the UK’s bond market?
q Short rates The first effect will be that UK short-term interest rates will converge towards those of the euro zone. This is the inevitable result of handing over monetary policy to the European Central Bank. The UK base rate will be whatever the euro short rate is, very possibly a lower rate than today.
q Long bond yields More important is the fact that the whole range of UK gilt yields will also converge. This has enormous implications for long-dated gilts.
The chart shows how long-dated gilts yield substantially less than their euro equivalents. This is the result of well-known technical factors influencing the gilt market – namely, the lack of government supply of gilts, owing to the healthy state of the public finances, at a time when pension funds are forced buyers on account of the minimum funding requirement. Up till now, pensions funds have had to buy long gilts because they are reluctant to take the currency risk involved in buying overseas bonds. But once the UK has joined the euro and gilts have been re-denominated from sterling into euros, they will be able to buy any euro-denominated government bond they like, be it issued by Spain, Italy, Germany or even Greece (which will have joined by then). Why buy gilts at 1% less yield than French or German government bonds?
In reality long-dated gilt yields will naturally move to converge with French and German government bonds to eliminate this anomaly. The convergence will come through gilt yields rising rather than euro yields falling. This is because the pool of available assets will increase substantially. The long end of the current gilt market (the FTSE-Actuaries over 15 year index) totals five stocks (dropping to four by year end) with a market value of e108bn (dropping to E86bn by year end). The current over 15-year Euro-zone market has 20 liquid issues with a market value of E238bn. The combined long bond market available to UK pension funds will therefore almost triple in size. And a rise of 1% on current long-dated gilt yields will result in a capital loss of approximately 11%.
q Index-linked/bond yields The index-linked gilt market is a peculiarly British institution but it will not escape the fall-out of euro entry.
The current UK index-linked market (as measured by the FTSE-A overfive-year index) contains eight stocks with a value of e100bn. In the Euro- zone only France has issued index-linked bonds, totalling e13bn. The French issues have a real yield of 3.6% compared with a real yield of only 2% on the UK market. The case for convergence in yield is less powerful here because of the small size of the euro market and the link specifically to local inflation. Once the UK is in the euro, however, issuance by foreign governments and supranationals is likely to increase significantly. This is because real yields of only 2% offer an extremely attractive borrowing rate, one which they are unable to take advantage of at the moment owing to the lack of a mechanism to swap sterling index-linked proceeds into euros. Let us assume that the markets meet at the middle and real yields rise to 2.75%. This would represent a capital loss of 9.4% for UK index-linked investors.
q Corporate bonds The UK corporate bond market is approximately e360bn in size. The Euro-zone corporate market is e600bn. Moreover, the Euro Pfandbriefe market (mortgage-backed bonds) is e627bn. So the UK corporate market is going to become a drop in the ocean. Here, though, the impact will be positive. AA-rated sterling corporate bonds yield about 0.75% more than euro corporate bonds. UK corporate rates can be expected to move in line with those of the rest of Europe and this may result in substantial capital gains. UK investors should therefore be thinking of increasing their weightings in UK corporates at the expense of holdings in long-dated gilts.
q Sterling Perhaps the most obvious impact of joining the euro will be an end to sterling’s exchange rate movements against the euro. The sterling rate will be fixed against the euro. The rate at which it will be pegged will be a political decision but economists estimate a fair-value range of between 2.85–3.05 against the old Deutschmark. Sterling’s current value is DM3.25. Euro-entry will therefore mean that sterling will depreciate by between 6% and 12%. Clearly UK investors should be considering increasing their exposure to Euro-zone assets ahead of this depreciation.
q Bond portfolio benchmark indices The final impact on the UK bond investor is that all the old FTSE-A bond indices will become redundant. Investors will have to familiarise themselves with and select new benchmarks, which are appropriate for the universe of euro bonds. The industry standard benchmarks are likely to be offered by Lehman Brothers, in particular the Lehman Euro Aggregate. This index includes governments, supranationals, corporates and Pfandbriefe.
The conclusions are twofold: firstly, UK investors need to start thinking about their response to the possibility that the UK will enter the euro within the next three years. Investors need to expand their investment horizons to include euro corporates, Pfandbriefe and Euro-zone index-linked bonds. Secondly, UK investors need to ensure that their fund mangers have the capacity to cope with the problems which euro-entry will bring. For us, at least, the euro has already arrived.
Jeremy Toner is director fixed interest at Foreign & Colonial in London