No change, then, in Britain’s bank rate. Which was no surprise.
The Bank of England’s Monetary Policy Committee has kept its benchmark rate at a record low 0.5% for a couple of years now. And with large parts of the UK economy still looking soggy, most MPC members were clearly wary about hiking bank rate today.
The trouble is, doing nothing is now also fraught with risk. Britain’s cost of living is surging far above the Bank’s official 2% target.
We’ll hear more about this next Wednesday, when the Bank churns out its new Inflation Report. But when inflation gets too high, the strain will show up somewhere in financial markets. Investors in gilts (British government IOUs) already know all about that – they’ve taken quite a pounding in recent weeks. Yet the outlook for the gilt market is set to get even worse. Here’s why.
The Bank of England wants to keep interest rates down
Bank rate is what the Bank of England charges commercial banks for overnight lending (the press used to call it the base rate until Mervyn King set us all straight). If it rises, high street lenders are almost certain to charge their borrowers more. So the Bank’s policy for the last two years has been to keep bank rate as low as possible to help Britain’s debtors. Indeed, many have seen their interest bills slashed.
But this is just part of the story. The Bank has also been keen to cut the cost of Britain’s long-term borrowing. The standard benchmark for this is the yield on UK gilts that mature (ie have to be bought back by our government) in ten years’ time.
If these long-term gilt yields drop, other interest rates that are priced off them will also decline. The hope is that this will make people want to take out loans and spend more money, which could help kick-start economic recovery.
But the problem for the Bank is that unlike with bank rate, it can’t officially dictate interest rate levels on ten-year gilts. So its answer has been quantitative easing (QE). The Bank has spent £200bn, most of it on gilts, using money it created at the flick of a computer switch.
What was the plan? When there’s a huge buyer – in this case the Bank – in any market, prices are likely to rise, meaning yields must drop. And when QE started in early 2009, gilt values rose while yields fell. Just six months ago, UK ten-year government bonds yielded 2.8% a year. And in the US, copycat moves by the Fed had similar effects.
QE has backfired for bond holders
But here’s the problem. That 2.8% was an artificially-low yield that couldn’t last. Pumping bucket loads of extra money into the system is very risky. And for bond holders, the QE policy looks to have backfired. It has helped create inflation, which is a nightmare for bonds.
What’s happened is that large chunks of Britain’s (and America’s) fresh QE cash have since ended up in the hands of City traders, who like nothing more than a good punt.
Commodity prices around the world might well have risen fast anyway as emerging market demand has increased. But add in speculative buying with that new QE money, and commodities have surged. Global food prices are up around 50% over the last 12 months.
In turn that’s driven the global cost of living up sharply. In Britain, annual inflation is now 3.7% for the consumer price index (CPI) and 4.8% for the retail price index (RPI), which includes housing costs. The Bank freely admits CPI will rise over 4%, while some analysts see it hitting 5%.
As the IMF recently pointed out, inflation isn’t great news for most asset classes. But it’s bad news for gilts in particular. Who’d want to buy an investment that yields 2.8% when your money is devaluing much faster? No wonder that since their August 2010 low, ten-year gilt yields have climbed to nearly 3.9%, meaning bond prices have since tumbled.
Hopefully that’s no surprise to Money Morning readers – two months ago we warned that the 30-year bull market in government bonds looked like it was ending: Is this the end of the great bond bull market? But what’s in store for gilts now?
Things will only get worse for gilts
Well, there’s another huge nasty out there. Our government owes vast sums of money. It’s just admitted that when the liabilities of partly state-owned banks RBS and Lloyds are included in our national debt – what we owe as a country – then Britain’s net debt at end-December was almost £2.3 trillion.
That’s over one and a half times our annual national income. Worse, our state borrowing is still climbing, despite government austerity programmes. Rising inflation plus rising debt spells big risks for gilt holders. And to compensate for these, investors lending to the UK are likely to insist on a future return that’s way higher than today’s.
In other words, expect higher yields and lower prices. This chart sums it up. ten-year gilt yields (the yellow line) have risen recently as the effects of QE have already worn off. But they’re still at least 1% below the average of the decade prior to the Great Recession and QE.
And look at the purple line. This is the ten-year gilt yield minus the RPI – ie the inflation-adjusted return that holders receive. At a positive 6%, this looked great 18 months ago when inflation turned negative.
But now, despite the latest surge in gilt yields, holders of these bonds are losing around 1% a year after allowing for inflation. As the latter climbs higher, the financial pain of holding gilts will grow.
And there’s an extreme long-term history lesson here too. To get back to their average yield over the last 100 years – which looks on the cards – ten-year gilts would need to return 1.5% more a year. That would really put a dent in prices.
In a nutshell then, gilts still look a lousy bet. We’re watching the situation closely – now you can easily track the latest yield moves on gilts and a range of other government bonds on our website here.
And if you’re interested in a ‘buy and hold’ way to play this story, my colleague Simon Caufield wrote about it in a MoneyWeek magazine cover story last October. His advice still holds good – and you can read the piece free here.
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