An Australian Bond Vigilante Discusses the Ashes

After narrowly avoiding defeat in Cardiff, England won the second Ashes test at Lord’s and is heading into the Edgbaston test match with a 1-0 lead. For those of you not familiar with cricket and this contest, see here. As the sole Australian and new member on the team I expected a bit of ribbing from my fellow Bond Vigilantes. But not this much. So rather than debate the possible outcome of the Ashes series, I thought it might be interesting to assess the Australian and UK economies and how they have performed over this very interesting period in financial history.

As a bit of a background, Australia is currently the world’s 19th largest economy by purchasing power parity GDP, with a size of $825 billion in 2008. Following a recession in the 1980s, Australia has enjoyed 17 years of expansion, aided by growing demand for commodities and robust government policies.

Despite the large shock (equivalent in cricketing terms to losing McGrath, Gilchrist and Warne) that the financial crisis has caused to the economy, Australia is only one of three OECD countries to have avoided recession so far (the others being Poland and Luxembourg). The Reserve Bank of Australia and the Government were quick to act once it became apparent that the global economy was in some serious trouble. The RBA cut interest rates from 7.25% to 3.00% in the space of just 8 months, helping highly levered consumers and businesses. The Government aggressively swung the fiscal surplus – the result of soaring tax revenues from mining companies and record low unemployment levels – into deficit by announcing large infrastructure projects and $900 handouts to Australian taxpayers.

During 2008/2009 the Australian cricket team performed above expectations, winning two series out of three. Not a bad result considering the loss of key players. The Australian economy performed equally well.  Growth has been supported by strong demand for Australian exports, particularly commodities, and like many other developed economies the business sector has responded by cutting expenditures, reducing debt levels and raising new equity. The unemployment rate has been rising but remains low at 5.8%, versus 7.6% in the UK (and considerably lower than some other developed economies – see previous comment here).  House prices have fallen, but by less than 7% versus about 20% for the UK.

The past year has been simply terrible for the UK. Not only did England lose two test cricket series to India and the West Indies in 2008 (and one win in 2009), but the UK economy has now declined by the largest year on year amount since the ONS started recording GDP statistics in 1948. For a history of what has happened in the UK economy there is no better place to get up to speed than by reading the archive material on this very blog.

It is now clear that the ‘NICE’ (non-inflationary, consistently expanding) decade is behind the UK and considerable challenges face the economy. We have written about the measures undertaken by the Bank of England and the UK government to support its financial sector in the midst of the crisis and the coming wave of gilt issuance that will be required to finance government guarantees. Additionally, markets are concerned about the impact that the end of quantitative easing is going to have on the economy.

Looking at bond markets, the Australian government is rated AAA by S&P. Australian 5 year credit default swaps (CDS) are currently trading at 45bps. Australia has relatively high interest rates and an excellent credit rating. It should have no problems raising debt to finance budget deficits, should it need to do so.

The UK by comparison has been placed on negative rating watch by S&P as discussed here. The UK government may still be able to issue debt but will there be a point where markets think enough is enough? UK CDS are currently trading at 60bps. This implies that the market thinks that the UK has more chance of defaulting on its bonds than Australia does. To put this in perspective, Germany is trading at 29, Portugal at 57 and Ireland at 157. It should be noted that this measure of implied risk of default has fallen across all these countries as investors have become more optimistic on the global economy, meaning that there is a view that these countries are now less likely to default.

So like cricket, the case for one economy or one team is not so clear cut. England’s star batsman, Kevin Pietersen, is out for the rest of the series. QE looks to be ending in the UK, pushing up gilt yields. Australian captain Ricky Ponting had a shocker in the second test at Lords and needs to bounce back. The Australian Prime Minister, Kevin Rudd, has written to Australians saying they should brace themselves for rising interest rates, higher unemployment and budget cuts.

It’s going to be an interesting summer of cricket.

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.

Anthony Doyle

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