Thursday, July 09, 2009

Russian Roulette... With Your Money

Feel lucky?

According to one major international investor, putting money into the UK government bond market (gilts) these days is "like playing Russian Roulette".

And why's that?

Because the Bank of England's £150bn Quantitative Easing (QE) programme has generated some massive distortions in the gilt market, distortions that everyone agrees are wholly unsustainable in the long-term. The problem is that, as long as QE continues, the distortions could get worse. And because nobody can tell when it will go bang, unless you enjoy roulette, you'd best steer clear altogether.

Which goes some way to explaining why the big international funds have been switching bigtime from gilts to overseas government bonds, especially traditional safe haven German bonds (bunds). In the first two months of QE they withdrew about £12bn (April and May), a stark and worrying contrast to the £65bn they'd purchased over the previous 12 months.

As you will know, QE involves the Bank pumping massive amounts of cash into our financial system, supposedly in order to ward off deflation. It does so principally by buying up vast quantities of outstanding gilts. And that has had the effect of driving up their price way beyond what would be justified by underlying "fundamentals".

So the big international investors have taken fright. In the measured words of Andrew Balls, a managing director at Pimco, the world's biggest bond fund manager:

"Buying securities of nations involved in quantitative easing “adds another layer of complexity” to investment decisions that are already difficult given the competing forces of an unfavorable economic outlook and increased debt supply. “We prefer German bunds over gilts and Treasuries.”

We have always been concerned about QE. It is effectively running the printing press, which always always ends in an inflationary blow-out. And despite all that scare talk about deflation, here in weak sterling Britain, it still hasn't actually materialised (and see Liam Halligan here).
In fact, when you dig out the figures, it turns out we currently have the highest inflation in the G7 - even above Italy.

The following chart (drawn using HM Treasury's own data) shows that, while consumer prices are now falling slightly year-on-year across the G7 economies as a whole, our inflation remains firmly in positive territory:

If we focus on the actual gap between us and the G7 average, the picture is even starker:

And that is alarming. Because as we are all too aware, Britain has a long and painful history with inflation. For decades our inflation ran higher than our competitors, eroding our competitiveness, undermining sterling, and perpetuating a highly corrosive wage-price spiral. It took years of hairshirt restraint to rid ourselves of it.

The very last thing we should be doing now is cranking up the printing presses. And it's little wonder international investors are voting with their funds.

And there's another important point to note.

Despite the vast purchases of gilts by the Bank of England, gilt yields (roughly, the interest rate on gilts) have not fallen significantly. In fact they are now more or less where they were before QE began. Which tells us that, what with the debt mountain, the inflation, and the general policy hiatus, investors are seriously worried about just where Britain is heading .

And just remember this - on £1 trillion of government debt (which we will soon have even on the government's optimistic figures), every one percentage point on gilt yields eventually means an extra £10bn pa on debt interest costs. Which is an extra £400 pa tax for every single household.

So if gilt yields rose from their current level of around 4% to around say 7% pa - which would be a fairly modest rise - every household would have to find an extra grand a year just to pay the government's debt interest bill.
You know, the more I think about it, I'm not sure this is Russian Roulette at all.
True, we've got the pistol pressed to our temple. But in this version, every single chamber seems to be loaded.
Update: Yesterday's decision by the Bank of England to suspend the QE programme - at least for the time being - brought an immediate gilt market sell-off. Yields jumped by getting on for one-quarter percent, and are now one-half percent above German government yields. We should expect much greater increases when the Bank tries to reverse the £125bn QE it has already done.

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