Ditch gilts and get out of sterling: Britain is heading for trouble

Here’s what the next few years hold in store for the average British worker.

Your cost of living is going to keep rising. Your income will not keep up. So each and every year, you’re going to get a little bit poorer.

Meanwhile, what little savings you can scrape together will be shedding value too. Because interest rates on savings won’t be going anywhere.

In fact, they might even fall, because banks can get all the cheap money they want from the government, as long as they pass on a bit of it to homeowners who want to refinance their mortgages.

To cap it all, even if you can afford to go on holiday, your pounds won’t go very far when you get there.

Pretty miserable, eh? And that’s not me talking – that’s the message from the Bank of England itself…

The Bank of England has thrown in the towel

Yesterday’s Bank of England inflation report was a bit of a bombshell.

The Bank has hardly been a non-stop source of uplifting news in the past few years. But yesterday’s report just sounded like it was throwing in the towel. And that’s the key point to take away.

The Bank has been terrible at forecasting inflation in recent years. But normally it at least tries to pretend that it will hit its target. Somehow, our current “temporary” (it’s always “temporary”) inflation is always going to be under control within the next two years. Therefore, there’s no need to raise interest rates to bring it in line.

Now it’s dropped the pretence. Inflation is currently at 2.7% on the Bank’s target Consumer Prices Index (CPI) measure. It’s going to rise above 3% this year, and remain above 2% until 2016.

And bear in mind – the Bank has a consistent track record of underestimating inflation. This is probably semi-deliberate. I’m not trying to spawn conspiracy theories here. Part of a central bank’s job in controlling inflation is to keep people’s expectations down, as this can become a self-feeding spiral. So the Bank will have a natural bias towards keeping a lid on bad news about rising prices.

In short, our central bank has just told us that inflation is going to be higher than anyone had hoped for a prolonged period of time. And it’s not going to do anything about it.

That’s quite a serious shift. And markets are already waking up to it. The most obvious casualty was the pound, which slid against the euro and the US dollar. As Jason Conibear at currency group Cambridge Mercantile told ThisisMoney.co.uk: “Confidence in the pound was already thin. The governor’s admission that the inflation target is to be quietly ignored while the economy remains in intensive care has stretched it even further.”

You see, in more normal times, higher-than-expected inflation would boost the currency, because traders would expect higher interest rates to follow. But if the central bank decides it’s not going to tighten policy, then it’s a green light to dump the currency.

More worrying still is what’s happening in the gilts market. As James Mackintosh notes in the FT, the bond market’s “best guess” at inflation over the next ten years “has jumped this year”. It’s now near its highest level since the financial crisis. The ten-year gilt yield is now around 2.2%, and seems to have bottomed out in August last year (in fact, around about the time we published this bond market debate between Tim Price and James Ferguson).

Keep an eye on gilt yields

It’s no surprise investors are getting jittery. The Bank won’t raise rates because economic growth is going to be weak. But if ‘real’ wages (adjusted for inflation) keep falling, it’s hard to see where the growth is going to come from. The only goal left is to drive inflation higher and inflate away our debts.

But if that’s the plan, then why would anyone lend money to the UK at current interest rates? You’re just going to lose money.

This is a potentially serious problem. Keith Wade and Jamie Bilson at Schroders calculate that the UK government needs to borrow another £440bn by issuing gilts between now and April 2017. That’s being optimistic about it (which Schroders acknowledge). In short, “there is a sizeable wave of issuance on the horizon”.

Now, we all know that the gilt market isn’t what it used to be. The Bank of England used to own precisely no gilts. Now, via quantitative easing (QE), it owns £350bn (and has more to buy). That’s more than a quarter of the market. More importantly, it’s nearly half of the £800bn the government has issued since December 2007.

So who’s going to buy the next £440bn? The Bank of England might pick up some of it, but it can’t foot the bill for the lot.

Much of this is a question of confidence and perception. The idea behind QE is that it’s meant to spur growth by persuading investors to take more risks. It’s not there to give the government a way to fund itself at cheap rates.

What worries me is this. What happens if inflation goes a lot higher than the Bank of England expects? It got up to nearly 6% on the retail prices index in September 2011, for example. That’s when it starts to creep into newspaper headlines.

The Bank won’t be in a position to raise rates. But how many gilt investors will put up with that? The risk is that existing gilt holders start to sell, and drive yields higher. If at any point it looks as though the Bank is being forced to step in to do more QE, simply because no one else wants to buy gilts, that would be a disaster.

The government would likely try all sorts of things to prevent that from happening. Financial repression – forcing pension funds or banks to hold more gilts – is one method. But those sorts of moves won’t inspire confidence in the UK either.

It might seem a scary prospect but far stranger things have happened. I’ve been racking my brains and there’s still not a single major currency I’d feel comfortable taking a long bet on sterling against.

What does it all mean for you?

It goes without saying that we wouldn’t own gilts here. And we’ve already pointed out that you need to diversify your portfolio away from sterling: invest globally, and own some gold as insurance. We looked at how to do this in more detail in our recent currency wars cover story

I suspect this is going to become a much bigger issue in the year ahead.

• This article is taken from the free investment email Money Morning. Sign up to Money Morning here .

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  • Roger

    Should have done this a couple of years ago. when 15-12RMB= 1GBP, now, 9.**RMB = 1GBP, in a few year’s time, 6-4RMB = 1GBP. But the later part is speculation and may not get realized.

    But money week was signing down with China all this time.

    May be buy Japan is the solution now? GBP is in the race with Yen to see who falls the fastest!

  • Chester

    Underlying inflation in the things that matter has been significantly higher than the so called headline rate rigged by the Feds. Food, energy and fuel are what most people worry about, and they have been lied to. Consumers know it, the Feds know it, and now the bond markets are finally waking up to the risks of QE and impotent government. As usual, the market will be left to sort out the stupidity of inflating unsustainable debt at the expense of saving and wealth creation

    The US$ should ride highest when the levee finally breaks, but exposure to NOK and SNG$ is no bad option either. Any faith in the Euro surviving in its present form long term could be misplaced

  • Peter

    The Bank of England doesn’t forecast inflation. It creates it.

    The whole aim of this “bank” is to inflate away government debt at savers’ expense.

  • Changing Man

    Ok so assuming that prediction of falling GBP is likely to be realised but you don’t want to sell all your GBP- centric investments right now ( e.g. maybe you are nursing losses that you don’t want to crystallise) what should you do? Gold always seems to be a knee-jerk reaction on MW and with the current direction it is taking I’m reluctant to invest any more in it for now! What about some ETFS 3x short GBP, long USD or long EUR, or both? Any other suggestions?

  • charlesdb

    Why do you need Gold as insurance? If inflation rockets and Gold goes up, if you sell, surely there is a large Capital Gains Tax to pay – and by the time you have repatriated your Gold Insurance money, high or hyper inflation will have wiped off another chunk of Capital.

    My preference would be shares or housing as a hedge against inflation.

    Someone put me right please.

  • Antony

    If UK inflation rises further, interest rates are kept down (through policy plus some more QE to keep Gilt yields off the boil) and UK wages do not keep pace (and they certainly haven’t so far, even within companies that are doing well during this recession), then it is clear that the UK Gov “Grand Plan” for a UK recovery is to bail out those in debt (including themselves of course!). Shouldn’t the advice be: lets all hold hands and buy a house with the minimum money down, secure a 2% fixed rate for 5 years and watch that mortgage inflate away?? This all goes against the grain for me but can anyone convincingly argue against this?

  • Ben Dover for taxes

    It only takes one self satisfying politican ( i.e any of them) to screw the pooch harder in ANY country or a fruit loop in N Korea to get out of bed the wrong side and this mornings speculation is all in vain.

    With so much uncertaintly never mind not even half a chance of a good bet shouldn’t cash be held even more flexibly like in a multi-currency off-shore account? They are very cheap these days!

  • Changing Man

    Re 6#, Antony, the only fly in that ointment is if house prices collapse and you are left nursing negative equity? Your transaction costs will be high too with estate agents fees, solicitors fees, stamp duty. If you are currently renting and want to buy to live there then I would agree but if its a buy-to-let investment then you would be unlikely to find a mortgage at 2%?
    Morningstar have an article published just this afternoon on inflation- beating strategies and are recommending inflation-linked gilts via ETFS! These gilts did well for me in 2011 even though inflation was low – demand simply pushed the price up 25% over the year I held them. After a period of stagnation in 2012, they are on the move again! I would worry about the risk to the gilt market in general though as highlighted in MW?

  • Chris

    Yep another gloomy article-it always makes a lot of sense, however I am mindful of your house price predictions a few years ago-lots of graphs and trends, all made sense but house prices have not panned as you predicted. Perhaps you are using out of date predictive tools? Quantative easing has risen in the vocabulary and better or worse has kept house prices pretty flat-I’m for a house price slump to reset, by the way.
    So perhaps we will keep ‘kicking the can’ down the road without consequences -new economics !!

  • Antony

    Re #8: Changing Man: I am renting (sold in 2007). I have been a firm bear on UK house prices since 2006 (reason for selling in 2007) but not at lot has happened to HPs in my corner of the SE of England and the market remains significantly over-valued in spite all of the good reasons why it should have crashed. I still believe that there is massive downside risk in housing (in my area) but it is now much more cost effective to pay a mortgage every month than to rent (rent here is rising). I’m being dragged back towards the housing market kicking and screaming but I guess that this is exactly what the Gov want.

  • IJ

    Buy gold as insurance against what? Central banks are printing money like there’s no tomorrow, emerging market central banks have been buying record quantities of gold of late, and the gold price is … down, and may even collapse.

  • Changing Man

    Yes IJ and only this week I read that Mr Putin is buying it in a big way! ( Surprised MW’s “Resident Gold Expert” hasn’t been phoning-in with that news?). What will it take to get gold prices moving up again and improve the prospect of gold miners? Today I have just lost half my investment (yes -50%!) in Avocet Mining! Big ouch!

  • jrj90620

    It doesn’t seem to matter,how much govt screws up a country.Citizens just keep demanding more govt,to fix the problems govt caused.That’s why the situation is so hopeless.As long as voters are ignorant and greedy,in a fascist democracy,they have the power to keep electing politicians,promising “something for nothing”,while destroying the country’s wealth.

  • Roger

    When buying shares near the end of a bull market is very painful (often you see index up and share prices down), now is a painful period for shares for the short term anyway. For gold, this has been going on for sometime. Even if gold is to go to $2000, lots of pain is out there on this last leg.

    It make sense to buy when people are fearful and sell when people are cheerful. So is MW, buy engaging the redear’s comments, you know what you should do.

  • Grim

    Re comment 4. from Changing man: I bought 3xlong USD, short GBP on Tuesday. Wasn’t sure of diff. between that & 3xshort GBP, long USD. Price actions since are similar so I suppose there is no diff. although one is quoted in £ and the other is US$. I did this rather than open a US$ currency a/c because charges are less. Interested in comment 7. from Ben Dover re offshore ccy a/cs – how do you get one of those. Another line of protection could be a managed currency fund – found one from Investec but it’s longer term performance is not inspiring.

  • Banki Rodgered

    There is certainly no doubt in my mind – and there has not been for a long time – that we are well up a certain creek without a paddle.

    The only uncertainty I have in my mind is whether it’s a deflationary depression or hyper inflationary depression coming. For the gold bugs that are going to insist it’s hyper inflation please don’t reply unless you understand the difference between cost push and demand pull inflation and also have an understanding of the role the velocity of money plays in inflation. I do hold gold by the way.

  • dude

    this sucks .. i was thinking of visiting China this year .. and the pound is dropping like a stone

  • Boris MacDonut

    I first thought, John’s joking. Then I thought he may even be lieing. But I settled for how ridiculous.

  • Colin Selig-Smith

    Next step in the slow motion train wreck which has been entirely inevitable since our bankers chose not to allow our banks to fail.

    Companies have record cash on their balance sheets, they are going to have to use that to bid up the supplies they need to run their businesses. Use it or lose it.

    Hard assets.

  • Alec

    The government’s policy is going according plan. Create as much inflation as possibe, drive down the value of stirling and of course make sure the housing bubble is fully inflated until the next election, there’s really nothing else to add.

  • mark Cardiff

    We are in a currency war, they aer talking down the £ and it seems to have worked ,that was the point of the statement

    But it will do nowt for the man in the street as we are a net importer so yes we are going to get robbed by inflation at the cost of keeping the feckless in there house`s and the bankers in there ferari`s

  • mark Cardiff

    @ 6 Antony

    The only thing that will inflate away a mortgage is wage inflation
    And apparently that’s the wrong type of inflation according to the B.O.E

  • Tim

    @5 British gold coins are not subject to capital gains tax

    @6 what #22 said. So many people confuse rising prices with inflation! You can define inflation as rising prices if you like, but then doun’t tell me debt will be “inflated away”! Rising prices (as opposed to wages) make debt HARDER to pay.

  • Roberto Birquet

    The Bank of England doesn’t forecast inflation. It creates it.

    The whole aim of this “bank” is to inflate away government debt at savers’ expense.
    No Peter, it is trying to inflate away everyone’s (especially banks and mortgage holders) debt away. Five years on and people still think govt debt is the problem. Bloody Hell, wake up everyone!
    The job has been to bail out banks and overstretched mortgage holders by destroying the value of money. that is why there’s the zombie economy of no-one (but Chinese and Arab millionaires in central London) buying houses. Banks won’t repossess them and govt still complain about too high deposits. It’s too high prices and rents that’s squeezing the life out of the economy. And refusing to face up to economics reality, the zombie economy trundles on.

  • Roberto Birquet

    I’m being dragged back towards the housing market kicking and screaming but I guess that this is exactly what the Gov want.
    exactly! This govt goes on about debt, but it has always wanted more debt: more private-sector debt to bailout the bankers and landlords that are its constituency.

  • Oscar Whiskey

    Hmmmm, gold ramping again. Who would have thought.

  • Aff

    Roberto, I’m afraid I have to agree with Peter. I think some of the confusion is because many people think rising prices is inflation but that is not, that is just something that often happens as a consequence of inflation.. The BOE creates inflation which is inflation of the money supply. Central banks do this in order to take wealth from the productive and ditribute it into themselves. Wealth is not destroyed but is redistributed. In this case the wealth of the people who try to save is stolen from them in order to finance the central banks. In this kind of climate I think locking in a mortgage and watching the value of that debt dwindle away could be a good idea. Its something I’m thinking about.

  • pcmgoohan

    It seems to me that the best way to position myself against sterling falls is to buy both gold and dollars.
    It is interesting to look at gold over the last month.
    Priced in USD it is down considerably, priced in GBP it is flat.
    I think gold is likely to go through more of a sell off, and I would like to wait before buying more.
    But I don’t want to wait and buy it with devalued sterling.
    So I am thinking move sterling to dollars now, move it into gold when it appears to bottom out.

    Any thoughts?

    PS: On the house debt/inflation ideas above- I think it’s too late. The London effect was the product of low but stable sterling, not low declining sterling. Foreign buyers are not interested in seeing their precious Mayfair properties devalued in their native currency by 50%.

  • Ben Dover for Taxes

    Re Grim’s question @15- Barclays have an ibank account for £10 per month.

    Like Antony @ 10 I sold in 2007 expecting just a housing bubble, I moved to Spain last year (but still work in the UK on contract). I was hoping for a € collapse / exit and a nice cheap house here without mortgage, but trying to preserve my money (most of it is still in £) and guess what the hell the Sheep driving politicians will do next is becoming too stressful. We are all here trying to look for concenus, but I think the odds of finding the right answer are probably worse than the odds on winning the Euro Lottery!

  • Boris MacDonut

    #29 Bad mistake Mr for Taxes. You must have listened to MW as regards selling up. Merryn herself did so only to watch London prices rise by 15%. Which bit of “liquidity trap” do the so called economists not follow? There will be NO hyper infaltion, NO currency collapse, NO property plunge. Modern western economics is all about employment. The toffs have shifted the agenda to debt……they are wrong. Economies need jobs,spending,demand. One man’s debt is another’s asset. Get real.
    #29As for moving to Spain, are you mad? Spain is the third world.

  • jackanory

    They have had five years to fix this, do they realy think more and much worse of the same is going to fix this in the two years they have left!
    Carmeron give my regards to Brown

  • Realist

    Boris. You have got to get out more. Have you heard of any other city, town or village outside London???????Most have gone down in price and at best stagnated in the SE. So selling your house and investing it, you would of gained, just as I did getting on average %5.0 PA, while houses stagnate.

  • Ben Dover for Taxes

    Re Boris @30

    ahh Hindsight…how perceptive of you! I sold out becuase I saw the ’89 housing bubble and wanted to take the cash out before the next one.

    I live in Spain because of the weather and to be honest the company, is better than in the UK. I had enough of racing other rats and wanted a better quality of life…Yes Spain is not much more than a bunch of farmers partying on a housing bubble and it needs to return to tourism so needs a cheaper currency than the tourist have, but at the moment I will take care in a Spanish hospital over an NHS one given the need and it is a joy to drive on good quality roads built by my UK donated tax £’s. The Spanish have had a nice free ride on the cash provided by the northern EU countries, which is a lot better than paying for it but never getting it like in the UK….

    Spain IS the 3rd world…fair enough, but I know what I have unlike you in the UK who can only guess what the long drawn out journey down the ranking will be like!

  • Realist

    Ben dover. Well said. There is nothing wrong with Spain, at least you can get value for money, unlike ripoff UK. If Boris doesn’t have the latest gadget, he thinks his throat has been cut. There is more to life than what the UK has to offer.

  • Mike

    Your analysis as always very accurate and points towards advice in your Wealth Preservation Report. I hope I will be able to comment on this report in this conversation with three questions. Why buy dividend stocks if there is danger of dividend tax? I bought gold when I read the report am now seriously out of pocket. Buying foreign stocks/ funds such as BGS (good call by the way) is still on LSE so still vulnerable. I say instead, sell your property now and RENT put the money in US dollars in a US bank and move yourself and your SIPP abroad using QROPS. Maybe cheaper than staying here. Your W.P.R. is too lean

  • Mike

    Ben Dover, thanks for insider on Spain. I thought it would be a bit dicey, obviously not. I am lucky to a degree as I am retired but the UK scares me. We are seriously considering moving to ICELAND. Cheap property, zero crime, great health service, clean water, cheaper geo-thermal heating. Ok thicker clothes needed outdoors and winters a drag, but you can rent a nice house in Northern Cyprus for winter cheaper than anywhere in Europe. As the Shaolin Master said to David Carradine in Kung Fu “Time for you to leave!”

  • Mike

    Last comment regarding Iceland….

    Any country who bails out its people and their mortgages instead of bailing out the banks has my vote. I bet they do not feed their population Buteburgers either.

  • Boris MacDonut

    #32&34 Realist. You must be reading something other than my posts. If you read mine carefully enough you’d know by now I live nowhere near London and go their may be twice a year. I own few gadgets.No mobile phone, no satnav’,no Ipod.In fact beyond this computer I am quite the dinosaur. But I have a major downer on Spain(and Cyprus),which are awful backward places.

  • jackanory

    Boris, dont you realise that England will end up in the same place if we carry on going this way.

    Mr King can’t lose, he pedicts inflation will rise and so causing peope to panic and spend their money, therefore insighting inflation.
    It’s his last chance to create growth and go out in glory.
    Pure propaganda!
    AND HOUSE PRICES WILL STILL FALL, it’s just when is the question

  • Duncan

    Boris you only need to read the first 8 words of 32.

  • Duncan

    Boris you only need to read the first 8 words of 32.

  • Boris MacDonut

    #39 .How would the UK end up like the Eurozone countries?. We are a modern western democracy with a huge economy and our own central bank. The markets are not spooked by the likes of the UK just like Japan.

  • smlaing

    It’s why there is a massive precious metals smash right now and it will continue for another year. The supply is dissipating but they continue to smash the price with paper. They absolutely have to keep a lid on the current price. I actually expect the biggest move against precious metals ever seen to come in the next 18 months. Gold is most definitely going to be a part of the next currency paradigm. They have to shake out the weak hands and will eventually consider confiscation from the rest.

  • jackanory

    42.Where’s the “Great” gone from Britian?
    We used to be the leaders in engineering and hold our heads high in the knowing we had a superior militry force.
    Now we only have a service sector left and half of an aircraft carrier.
    Once the banks have realised they have bled us dry and pushed us all into so much dept that can’t reversed they will leave and your precious central bank will fold.
    It’s time to become Great again and take control, unforunately that means turning back the clock

  • Realist

    #42 Boris. We might have a big economy, but it is not large enough in the right sectors.

  • Chucklebus

    How does devaluing sterling help if other countries all do the same with their currencies? Surely we all drop together and nothing really changes. You might get a competitive advantage for a short time, but it wouldn’t last would it? Meanwhile prices for the UK consumer rise, so we spend less especially as we’re not going to borrow any more, so more UK business [that don’t do exports] go bust and unemployment rises, meaning less tax and more benefit being paid out. Or am I missing the point?

  • Critic Al Rick

    @46. Chucklebus

    As I see it, devaluation of a currency is largely a function of relative QE within that currency.

    Hence, as we’re so dependent upon imports (even for essentials), and whilever a lot of those imports come from a Euroland which is not as QE trigger-happy as the UK, the cost of living in the UK will go up. The greater the differential in relative QE, the greater the rise in the cost of living.

    So, eventually, we’ll end up worse off than Greece is now (probably a lot worse) anyway. In the meantime the West sinks relative to the BRIC, and the richest inviduals in the West get richer.

    If your point is: “we’re stuffed”, then I would say you’re not missing it!!

    To be a viable entity, the UK needs to become effectively self-sufficient in essentials. How it gets there remains to be seen, but I can imagine the journey won’t be pretty.

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