Thursday, March 26, 2009

Gilt Strike


These patriotic gents would never have taken strike action

Yesterday's failed auction of 40 year gilts underlined a few ghastly truths we may possibly have mentioned once or twice before.

Let's start by asking whether you would be prepared to lend to the UK government? Right here and now. Today.

In particular, would you lend the government money at a fixed interest rate of 4.25% for 40 years?

Just consider the risks.

First, lending fixed rate money to any government for such long periods lays you wide open to default by inflation. True, UK inflation has been very subdued during the last decade - just 1.8% pa on the CPI measure. But over the last 40 years it has averaged nearly 7% pa. And a repeat over the next 40 years would mean you'd lose around 60% of your investment in real terms.

Sure, it's possible the government will stick to its 2% inflation target for the next 40 years. And sure, it's possible that the Bank of England will somehow deliver it. But with a mountain of debt to work off, our currency already stuffed, and the printing presses roaring, it's rather more likely gold pigs will fly out of my butt.

Second, the supply of new gilt issuance over the next several years will smash all previous records. It will be humongous:

Supply on this scale is bound to put downward pressure on gilt prices (and upward pressure on yields). So why would you buy now when you will be able to buy much more cheaply down the road?

Third, gilt prices are currently propped up by the Bank's programme of Quantitative Easing. They are using up to £150bn to buy bonds on the open market, and virtually all of them are gilts.

That's fine for existing gilt holders, because they can sell out at premium prices artificially inflated by The Simple Shopper With The Big Purse.

But for anyone thinking of buying gilts, they are now faced with prices which have been temporarily ramped by the Shopper. What's more, at some stage (TBC), the Shopper will flip-flop and start selling. Prices will then plummet from their artificial highs down to artificial lows. Clearly, the Shopper will make an horrendous loss on the whole deal, but hey, he's the Shopper, and he doesn't care because it's not his money.

But you care. And why would anyone of sound mind ever want to be on the same side of the market as the Shopper?

So no - you wouldn't have been any keener on those gilts than the investors who failed to show up yesterday.

And you must be wondering why anyone would be buying right now?

Well, some investors have little choice. In particular, pension funds need to buy in order to match the future liabilities to their pensioners. They're forced to do that under government regulation. Insurance companies have similar needs for matching assets, and taken together these investors hold getting on for half of all outstanding gilts.

Investing in gilts is purportedly their low risk strategy - gold-plated security and future investment income matched to future cash liabilities.

Unfortunately, when inflation accelerates, for the pensioners who actually need the cash, it's very far from low risk. As they get older, they will discover their gilt-funded pensions buy less and less with every passing inflationary year.

But hey, by the time that happens, this present lot of politicos will have long gone. Starving pensioners will be someone else's problem.

Much more concerning in terms of the government's current funding problem, is the question of overseas investors. Over the last few years they have become vital to government funding, quadrupling their holdings of gilts:



When last sighted they were holding 36% of all our gilts - double the percentage just five years ago. And unlike Britain's pension funds, they do not need to buy gilts at all. They could easily switch their funds anywhere else in the world. What if they go on strike and decide not to buy?

The answer is we'd be well and truly in the mire.

Of course, words like "strike" are a bit misleading. G7 governments can always expect to get funding. But at a price. It's price that's the real issue here.

At present, our government is able to borrow long-term for 4% or so. But once those crucial overseas investors realise the Great Gordo doesn't have a clue what he's doing, things will look very different.

How expensive might it get?

Back in the bleak 1970s, long gilt yields reached 17%. At that level, £1 trillion of debt would cost us £170bn pa to service.

Or 13% of our GDP.

Ouch.

PS Today's gilt auction was much more successful. But that's because it was an issue of index-linked gilts - ie inflation protected. And with the higher inflation to come, such gilts will be much more expensive for taxpayers.

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