Government bonds, or gilts, aren’t usually of much interest to private investors. The gilt market isn’t widely open to most of us, and even if it were, it would be tough for even the most ardent investor to get too excited about it.
But that doesn’t make gilts irrelevant. Far from it. In fact, trouble in the gilts market could cause carnage in the things we really care about. From stocks, to pensions and of course mortgages and house prices – they all depend on what goes on in the gilts market.
And I do think we could see a blowout in the gilt market. Last Wednesday, we noted that investors have driven prices up to bubble-like territory. And on Friday, we saw how demographic and herding issues keep inflating the bubble further.
What could see this bubble burst? That’s what I want to talk about today.
Good business if you can get it
There are some who argue that a gilt bubble can never burst. Seeing as the Bank of England can simply print money and use it to buy gilts, then the market will always be in business. Right? Hmm, I’m not so sure…
The Bank of England can, indeed, create money and use it to buy gilts. But just like anybody else, the Bank of England has to account for its actions.
It comes down to two simple ledger entries on its balance sheet. The net effect of quantitative easing (QE) is this:
• Liabilities up (the cash created) – £375bn
• Assets up (the gilts purchased) – £375bn
In terms of the accounts, the two ledger entries net off.
Now, quantitative easing (QE) is quite a neat little trick. What happens is that the Bank of England creates the money and then charges itself 0.5% interest for borrowing it (remember, this is a liability, so they should pay interest on the money). It then buys gilts yielding around 2%, or 3%. Good business indeed. Wouldn’t it be nice if we could all create new cash, and simply charge ourselves 0.5% interest on it!
Threadneedle Investments calculates this interest rate carry produces annual profit of about £9bn. That’s 0.5% of GDP - serious money!
Only there’s a catch.
Remember, QE is only supposed to be a short-term measure. It’s anticipated that the Bank of England will at some point sell the gilts back into the market, and thereby reduce its inflated balance sheet.
But this would surely crucify the market. I mean, putting a halt to QE, thereby taking away the biggest buyer in town is one thing. But, at the same time, actually dumping its gilt holdings back into the market would be sure to cause carnage. And the longer the Bank of England continues its QE programme, the bigger the bubble gets.
That’s why I suspect they will never put the gilts back on the market. Not only would it crash the market, but it would be all but impossible for the government to raise new money through gilts.
QE to infinity?
So, does that mean we’ll never see the end of QE? Not exactly.
Ultimately QE is just a way of keeping the financial markets ticking over. And so far it has worked pretty well. It really isn’t over-cooking it to say that post-Lehman, the financial system looked set to implode. Today, most investors are worried about their savings. But not so worried that they are moving to cash them in.
Only there is a problem. As investors naturally start to draw down savings – for example, as retirees spend their pensions – the cash is released into the economy. And this is not good. Because there are only so many goods and services to go round. QE hasn’t changed that. And with more money chasing the same amount of goods, prices tend to go up.
We won’t fully appreciate the inflation wrought by QE until the financial savings work their way into the economy. In fact, I suspect the increased money supply is already having an effect. Ros Altman, director general of Saga, keeps banging on about the fact that the average pensioner’s basket of goods is inflating way quicker than your average bod in the street. Well, yes… that’s because pensioners are the ones carrying most of the new inflationary firepower.
And from there, inflation can accelerate very quickly. Why? Because investors will get nervous – especially all those gilt holders! Inflation erodes the real value of gilts. And once investors believe inflation is entrenched, they’ll surely (and finally) start to trim gilt holdings. And what starts as a trickle can very soon turn into a torrent.
2008, but much worse!
If the gilt market takes a tumble, where will investors go? Probably not equities – not if they’re looking for safety.
Cash would probably head out of the pound. And as the pound falls, it would cause inflation, exacerbating the drive out of gilts.
With nowhere else to put money, commodities could become popular. Again though, this would only cause more inflation as commodity prices work their way back into higher prices for goods.
Inflation begets inflation. It’s a disease of money. If the gilts market starts to unravel, the ramifications could be absolutely dire.
But remember, at this stage, a gilts crash is only an ‘if’ event. Perhaps the Bank of England will bring a halt to QE and our economy will work its way out of what looks like a nasty contraction the hard way. Perhaps they’ll even reverse the current batch of QE. Or maybe nervous investors will stick with gilts, while suffering a bit of inflation erosion. We can’t be sure of anything.
Except gold of course. We can be sure of that. And I continue to buy gold. The longer this protracted game of cat and mouse continues, the more dangerous the financial system gets. To my mind, inflation is already baked into the cake. The only question is how it comes out.
So I continue to visit my coin dealer… at the end of every month I hand over the cash, and he gives me my eight sovereigns. Though I’ve been doing this for a while now, I have no doubt that this may go on for some time into the future.
And I’m also on the look out for some decent gold miners. Simon Popple has convinced me that he thinks there are some great gold miners going very cheap right now. If you haven’t been reading Metals & Miners yet, you should have a read of this.
In the meantime, I’ll be keeping a close eye on the gilt market, inflation figures, and the velocity of money data. And I’ll keep you right up to date with gilts and the monetary experiments of the Bank of England as they unravel.
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