The big threat to your stocks, pension and mortgage

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.

• This article is taken from the free investment email The Right side. Sign up to The Right Side here.

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16 Responses

  1. 15/10/2012, J R WILLIAMS wrote

    I NOTE THAT YOU BUY 8 SOVEREIGNS A MONTH AND THAT REMINDED ME OF A NUMBER OF QUESTIONS BUZZING ROUND IN THE BACK OF MY HEAD: WHAT IS THE BUY PRICE OF A SOVEREIGN -v- THE SELL PRICE OF A SOVEREIGN?
    ALSO, HOW MANY SOVEREIGNS TO A TROY OUNCE OF GOLD
    AND WHAT IS THE MARGIN BETWEEN THE GOLD PRICE AND ITS EQUIVALENT IN SOVEREIGNS?

  2. 15/10/2012, bengt wrote

    JR

    A sovereign weighs nearly 8gms (7.988), but is 22 carat…

    so the gold content is 7.322 (7.988 x 22/24). I just multiply that figure with the ‘spot price’ per gramme to get the gold value.

    These days you can expect to pay 5% or more over spot. I see on ebay the premium is often more, but on occasion, you can get it pretty close to spot. But be aware, that some coins have collectibility value, so you can’t always compare like for like.

    Surprisingly, some of the half-sov’s have been going cheaper on e-bay (pro-rata)… I’m not sure why?

    Personally, I pay 5% above spot for my coins. It’s with a trusted dealer, no shipping and we have a deal where he gives me the average weekly price.

    Bengt

  3. 15/10/2012, Red Baron wrote

    “As investors naturally start to draw down savings – for example, as retirees spend their pensions – the cash is released into the economy” – Surely a pensioner will have less disposable income than when they were employed.

  4. 15/10/2012, Mark dK wrote

    Surely there will come time when the central banks are pressured into magically disappearing some of the gilts on their books through a new accounting trick, so “dealing with” the govt debt to GDP problem at the same time. The only question is how investors will react to this.

  5. 15/10/2012, Mark dK wrote

    Ha Ha! I promise I wrote the previous comment BEFORE I read today’s Money Morning article!

  6. 15/10/2012, bengt wrote

    Red Barron

    For sure pensioners have less income to throw about than others. But this is a demographic issue…

    Pensioners are adding demand, over and above an already increasing population’s demand.

    And fair enough, they’ve saved up for their retirement. But you can’t get away from the fact that they are consuming, but not producing.

    The UK population is getting very large, and her productive capacity is unlikely to keep up.

    This all sounds a bit Malthusian, I know

    Bengt

  7. 16/10/2012, Mike F wrote

    The title of the article includes the word ‘mortgage’ but I see no mention of mortgages in the article. As I going mad, or is there, in fact, no mention of mortgages in the article??
    I assume the threat to mortgages would be that interest payments would escalate with inflation and rising interest rates, although if one could cope with the higher repayments short term both the payments and more importantly the mortgage itself would be reduced in real terms.
    TIA

  8. 16/10/2012, Mike F wrote

    The title of the article includes the word ‘mortgage’ but I see no mention of mortgages in the article. As I going mad, or is there, in fact, no mention of mortgages in the article??
    I assume the threat to mortgages would be that interest payments would escalate with inflation and rising interest rates, although if one could cope with the higher repayments short term both the payments and more importantly the mortgage itself would be reduced in real terms.
    TIA

  9. 16/10/2012, Joe wrote

    @ 7 Mike F

    It’s in the second paragraph:

    “From stocks to pensions and of course mortgages and house prices – they all depend on what goes on in the gilts market.”

    And yes, if interest rates took off, so would your mortgage payments if not on a fixed deal.

    That’s what I took Bengt to mean.

  10. 16/10/2012, Spike wrote

    “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 have benefited the most from QE as it drove up the value of their assets.”
    Pensioners’ basket of goods inflates at a higher rate because unavoidable expenses (e.g. energy, council tax, water etc) inflate at a quicker rate and represent a much greater proportion of their total spend than the average bod’s. This leaves far less disposable income to be spent on consumer goods.

  11. 16/10/2012, Bengt wrote

    Spike

    I agree – food, energy, water – all good examples of where there’s an awful lot of demand chasing too few goods.

    As you say, pensioners aren’t spending that much on consumer goods – and consumer goods aren’t inflating that much!

    This isn’t as simple as I make out here. And I know there are extroginous factors affecting commodity prices.

    But I can’t help but think there’s a fundamental flaw in the financial savings model that’s been built up during the post-war years. Financial savings offer promises on future productive capacity. But (especially in the UK) the savings have not been converted to investment to improve production capabilities. Hence inflation to devlaue the financial promises.

    Bengt

  12. 17/10/2012, Andy N wrote

    What about the deflationary effects of personal debt, bank balance sheets and government austerity?

    To what extent are the forces that are sucking money out of the system acting as a counterweight to the inflationary effects of QE?

  13. 19/10/2012, Boffy wrote

    I’m surprised you can buy 8 sovereigns for just 5% above spot. Several years ago I was buying sovereigns and krugerrands from one of the main gold bullion dealers. The latter were 5% above spot, but sovereigns were more like 8%. Moreover, I was buying not 8 but 50 sovereigns at a time, and 15 krugerrands.

    The benefit of sovereigns is that they are still classed as currency, and so not subject to Capital Gains Tax!

  14. 19/10/2012, Steve wrote

    Boffy,

    I don’t know where Bengt buys his sovereigns but I do know that there’s a huge difference in price between dealers.
    e.g.
    1. http://www.coininvestdirect.com/en/gold_coins/full-sovereign-elizabeth-gold-1957-now.html

    2. http://www.taxfreegold.co.uk/wesellsovereigns.php

    322 euros from coininvest is about 262 pounds. (approx 5% premium)
    Chards is asking 280 pounds. (approx 10% premium).

    I have used both dealers with no problems. Others I have used:
    http://www.vatea.de/index.php
    http://www.proaurum.ch/home/preisliste.LU.html

    Steve

  15. 20/10/2012, Lupulco wrote

    Lets assume that the G20 lean on the financial Institutions [as they do] after the 0-1% MLR bail out throughout the G20.
    They a] collectively agree to raise the MLR by 4% over the next 3years at say 0.5% every 6 months.
    b] They increase the liquidity ratio of ALL financial Institutions to say 10-15% over the same period. The Gilts held to form part of this liquidity.
    c] Short term debt Credit Cards etc to be fixed @ MLR x 4 and the capitol repayment to be 10% pm not 5% as now. Reduce the profit margin and encourage debt pay down
    d] Mortgages to revert to 3-4 times annual income or repayments not to exceed 25% of monthly net income. [repayment mortgage only, max period of 20 years.
    e] As most people see buying property as an investment, not just somewhere to live, also the people who lend the money you have borrowed have to pay tax on the % earned @ 20%. It is only fair that a capitol gains tax of 20% should be paid on property.

  16. 12/11/2012, 4caster wrote

    I am surprised that Bengt writes “The gilt market isn’t widely open to most of us …” I have never had difficulty buying and selling gilts. In fact I can buy and sell them online at real-time prices through my Alliance Trust Savings Stocks and Shares ISA, provided they have more than 5 years to maturity when I buy them. A similar procedure is available to SIPP-holders. Of course it is necessary to deal in quite large amounts, otherwise the trading cost becomes a significant drag, because prices do not change as quickly as those of equities.
    Whether is it sensible to buy gilts now is a different matter. Index-linked, arguably, but I would not touch conventional gilts.

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