Tuesday, January 05, 2010

A Postcard From Newport Beach

As you may have heard, we've just received a rather distressing postcard from plush Newport Beach in Southern California. It's from Mr Pimco, the world's biggest bond investor, who lives nextdoor to Newport's famous Fashion Island. Here's what he says:

"...we are currently cutting back in the U.K. because... supply and demand dynamics are likely to be negatively affected as borrowing rises and central bank buying declines."
Translating, what Mr P is worried about is that UK government bonds (gilts) are about to lose their biggest buyer - to wit, the UK government. He's understandably concerned that gilt prices will then crash, and is quite sensibly heading for the exit before the stampede.

We've blogged this many times (eg see here). For the last year, HMG has funded its humongous borrowing requirement by having its wholly owned subsidiary, the Bank of England, buy up a corresponding quantity of gilts in the open market. The subsidiary has funded these purchases by the simple expedient of printing money. The process has ensured that HMG's borrowing has not undermined the market price of gilts. Which in turn means that HMG has been able to borrow at historically low interest rates.

Unfortunately, this terrific scam is now coming to an end. Having printed £200bn of new money, even the Bank's most rabid inflation monkeys seem to have decided they'd better let the presses cool down for a while. Savvy investors like Mr P are sensibly taking the chance to leave before the inevitable kerrrunchh.

So where does this leave us?

The key indicator of market confidence is the interest rate the government must pay on its bonds - ie the gilt yield. And here's how that looks over the last 2 years (10 year benchmark gilt):

There are a couple of points to highlight. First, the average yield we've seen since the onset of the financial crisis has been extraordinarily low. Second, over the last month or so, it has spiked up through the top of its post-crisis range. And that's almost certainly because of the actions of people like Mr P.

What if all international investors dumped their gilts?

Overseas investors currently hold around £200bn of gilts, around one-third of the total outstanding (see here):

So a mass dumping would be a serious problem.

It would be especially serious over the next few years, given the massive amount of new gilts HMG intends to issue - well over £200bn both this year and next:

Just take a moment to clock that chart (from the Debt Management Office). Even on Darling's wildly optimistic fiscal projections, HMG's net issuance of gilts over the next 4 years will exceed its entire cumulative issuance since the dawn of time up until now.

That will make enormous demands on gilt investors, especially those who are already heading for the exit. There is absolutely no way it will be possible on anything like current terms.

Gilt yields back above 5% are a certainty, and they could easily go a lot higher. Last time through in the 70s, they peaked at an eye-watering 17%.

And with a National Debt of £1.5 trillion (Darling's forecast for 2014), every additional 1% on gilt yields ultimately means an extra £15bn pa on debt service costs. Which is another 4 pence on the standard rate of income tax. And that's without correcting for Darling's forecast optimism.


And do you know the cherry on this particular cake?

Pimco's head honcho in London is one Andrew Balls. Andrew Balls, brother to Balls Balls - Sorcerer's Apprentice to the Great Gordo himself.


I'm afraid I may need to break my New Year's alcohol resolution.

PS There's another reason we should listen to what Pimco says about dodgy government debt. Newport Beach is in Orange County, and Orange County famously went bust in the early 90s. Why did it go bust? Because its Treasurer decided he was a financial genius, took a whole series of reckless financial decisions, and when they started to go wrong, filed false and misleading financial statements in an attempt to cover up (see here). At least nothing like that could possibly happen here.

Update (6-1-09) - Pimco's Head of Global Portfolio Management has since stated that the UK has a greater than 80% chance of being downrated from the top AAA credit rating. He says: "It's just a question of when on the current trajectory, not if. Based on what we know today about the debt trajectory and about the inability to adjust that, I think it's greater than a 50% likelihood for sure. Call it more like 80%." HMG's debt reduction plan "is lacking in conviction and it is lacking in details." Presumably Brother Balls agrees 100%.

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