Will the UK scrap the short-selling ban on gilts?

The UK is planning to remove EU restrictions on short selling of sovereign bonds.

>> Brexit is a success or failure?

It is fair to say that the UK gilt market has had a pretty rocky time of it over the past nine-months. It started with the debacle of the blink-and-you-missed-it Liz Truss government last autumn, whose fiscal plans upended gilts and nearly broke the pension market. Pressure on gilts resumed after a brief reprieve as inflation surged and the BoE was forced to belatedly increase the size of rate hikes last time out. Of course, all major-country bond markets have been hit by the surge in inflation, but gilts have performed particularly poorly.

For instance, 10-year gilt yields are now more than 60-bps above 10-year treasuries which compares to being around 50-bps below treasuries before Truss became PM. In short, the market still looks vulnerable, so should we be worried by the Treasury’s announcement earlier this week that it intends to end the short-selling ban on gilts? Is it a good move that will aid market liquidity, as the Treasury suggests, or a recipe for disaster that could make the recent strains in the gilt market not only look like a tea party compared to what could be in store if inflation continues to run out of control, but put the pound in jeopardy too?

To answer this, we need to look at the circumstances surrounding the UK Treasury’s recommendation. The UK feels it was bounced into a short selling ban by the EU in 2012 following the euro zone debt crisis. It was the only country that abstained from the vote. Now that the UK is free from the EU the UK Treasury clearly feels that the ban should be removed. To see whether this invites pressure on gilts, and perhaps the pound as well, consider that the UK is in a very different position to euro zone countries.

The euro zone countries issue debt in euros but cannot print euros and hence monetize in the extreme case of a debt crisis. This arrangement helps to prevent a collapse in the currency but arguably it increases the risk of default quite significantly – which is why a number of euro zone countries had to be bailed out back in 2010-12. Because the UK issues gilts in sterling and the BoE prints sterling, monetisation is available which reduces the risk of default even if such a scenario would clearly cause substantial tensions.

In theory, at least, it seems understandable that the EU retains the short-selling ban, and also understandable that the UK wants to remove it. Again, in theory, the UK’s different position to the EU suggests that if there is a speculative attack it is more likely to be shared between the gilt market and the pound, than fall primarily on the bond market, in the case of the euro zone.

In fact, we could argue that this is exactly what we’ve seen if we look at how the euro traded during the 2010-12 debt crisis, where it was very stable (at least relative to EGBs), compared to the intense pressure that fell on both the pound and the gilt market during the turmoil last Autumn. Could the removal of the ban on short sales of gilts increase the risks to not just gilts but also the pound?

>> The pound’s rally might not occur again in 2H23

The standard Bank said it would – if the UK authorities go through another madcap fiscal moment like that we saw last autumn. But on the assumption that the current government has come to its senses, and that the Labour Party, which seems to be the government-in-waiting, talks in much more fiscally responsible terms than the Party that stood at the last election under Jeremy Corbyn, then we do not think there is much to fear in any removal of the short-selling ban.

On the flipside, we can also ask whether the government’s post-EU financial reforms, such as this one, might increase the attraction of UK assets to overseas investors and so lift prices – perhaps including the pound? There is already quite a bit of evidence that the post-Brexit financial landscape is proving a struggle, such as the migration of many stock market listings from London to other centres, such as New York.

In time, the standard Bank suspects that post-Brexit changes to UK financial legislation will help the UK claw back some lost ground, possibly working to the benefit of its asset prices. But the key here is that it could take some time. In the shorter-term, however, we do not expect UK assets to be undermined by the proposed ending of the short-selling ban on gilts.