Bank of England figures on gilt purchases cast doubt on Chancellor George Osborne’s claim that record low yields represent a vote of confidence in the UK’s economic and fiscal fundamentals. Yields, instead, have been driven down by a combination of QE, regulatory-inspired bank buying and capital flight from the Eurozone (i.e. a loss of confidence in competing markets).

In November alone, the Bank bought £23.9 billion in QE operations while overseas investors ploughed £16.3 billion into gilts – just below a record £16.6 billion in September 2008, when Lehman failed. With the Debt Management Office (DMO) issuing “only” a net £11.9 billion, official and foreign demand was sated by UK non-bank investors and banks selling on a large scale – reflecting, presumably, a judgement that yields were artificially and unsustainably low. UK non-banks reduced their holdings by a record £23.1 billion in November following a £16.7 billion disposal in October.

The dominant role of policy-related and foreign buying is not new but is reflected in figures covering 2009-11 (i.e. up to November, a period of 35 months) – see chart. The DMO has issued a net £475.1 billion of gilts since the start of 2009 – equivalent to a third of annual GDP. The Bank has hoovered up £240.9 billion of this flow leaving £234.2 billion – less than half – to be absorbed by “the market”*. Capital flight from the Eurozone contributed to foreigners buying £153.8 billion with the remainder absorbed by UK banks, largely reflecting regulatory pressure to increase holdings of “high-quality” liquid assets. Despite the supply avalanche, therefore, UK non-bank investors – the traditional buyers of gilts – have actually reduced their holdings, by £6.1 billion, since the start of 2009. They bought £37.2 billion in the prior three years (i.e. 2006-08).

With conventional market drivers suppressed by price-insensitive official and foreign demand, the key determinants of whether / when yields will recover will be QE and regulatory policies and the success or failure of Eurozone stabilisation efforts. UK economic and fiscal trends, as well as rating agency decisions, are probably of second-order importance.

* It would have been more efficient for the DMO to issue directly to the Bank at the then-prevailing market prices but this would have made explicit the monetary financing of the budget deficit (as well as denying gilt market-makers a profitable arbitrage between the two public sector bodies).

The forecast here that the global economy would regain momentum in late 2011 has received further support from data released over the holiday period.

A weighted average of new orders indices in G7 manufacturing purchasing managers’ surveys moved above the breakeven 50 level in December, as had been suggested by improving earnings revisions – see previous post.

While the US remains in the lead, most other countries reported improvement, albeit from weak levels.

Strong Korean exports in December are a further sign that the global and Chinese economies are holding up.

Global manufacturing activity is benefiting from strength in consumer demand – G7 retail sales volume consolidated recent gains in November. A widening sales / output gap has aided inventory adjustment and should lead to increased production in early 2012, assuming no demand relapse.

Firmer demand, in turn, was predicted by a pick-up in global real narrow money expansion from spring 2011. The six-month growth rate of G7 plus emerging E7 real money ticked down in November but remains healthy, suggesting that the improvement in economic momentum will be sustained through spring 2012 at least.

The global real money pick-up, however, has been heavily dependent on US strength, which is now fading. An optimistic economic scenario for later in 2012 depends on a recovery in real money expansion elsewhere – particularly Euroland and the E7. E7 numbers have started to improve and Euroland could follow, based on slowing inflation and recent policy easing.