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AAA Q&A: why the UK's rating downgrade matters
Moody’s decision to strip the UK’s of its prized AAA credit rating late last Friday has huge political, economic and investment significance.
What does it mean for UK government bonds?
The impact on UK government bonds, or gilts, is crucial. The government has so far managed to fund itself cheaply with low interest payments on its debt due to demand both from overseas and the Bank of England’s QE purchases.
First off, it is important to note that a downgrade was long expected and ‘priced-in’ to assets including government bonds.
Many factors affect gilt prices, including inflation, confidence in the public finances and ‘safe haven’ demand. The latter has already been eroded as investors have seen improvements in the eurozone, leading them to compare the UK’s finances unfavourably. But it is supported by the government’s control over its own currency, unlike eurozone nations, which depend on central bank control of the euro.
If other ratings agencies follow Moody's example, it could discourage institutional and overseas investors from lending to the UK. This would undermine the government's efforts to turn round the economy. However, big investors like this have a shrinking pool of AAA rated investments so ‘flight’ from UK gilts should be limited for the time being.
What’s more, the Bank of England should support gilts. More QE will mean it will buy more gilts, keeping their prices high and their yields (interest rates) low. The Bank, which has become increasingly tolerant of inflation in order to generate growth, will likely continue down this path.
Next: What does it mean for Osborne and the economy?
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