Could this be the trigger for a sterling crisis?

‘Bubble’ is one of those terms that gets bandied about rather liberally, with no one quite agreeing on what it means.

Some say it’s merely a rapid price rise, with a contraction to follow. Others say it’s a rapid price increase, which bears no relation to underlying economic fundamentals. This creates an artificial market, meaning that rapid drops are inevitable.

I like to define a bubble as “a bull market in which you don’t have a position”.

All three of these definitions could easily be applied to the US long bond (the 30-year Treasury) and UK gilts. So are these governments bonds in a bubble? And if so, when will it pop? And what will the consequences be?

Government bonds are just like the sub-prime bubble

One thing about bubbles is that they tend to catch people unawares. There are a few canny souls who see them for what they are, but plenty get caught with their trousers down. So many people have already labelled UK and US sovereign debt as being in a bubble, that you wonder if any bad news is already ‘priced in’.

Yet, on the other hand, there are millions caught up in this sovereign debt ‘bubble’, many of them unwittingly. Almost all large institutions, from pension funds to hedge funds, high street banks and global investment banks, own large quantities of government bonds. They have to. No investment better ticks the regulatory boxes.

And statistic after statistic makes you shake your head and say: “this isn’t for real”. The Bank of England has bought about 50% of UK government debt issued since 2009. It now owns something like 30-35% of all existing UK government debt.

There are all sorts of justifications put about for the BoE doing this. Most boil down to the perception that if it doesn’t, everything will fall apart. But there can be no doubt that this is an ‘artificial market’.

Bonds have rarely been issued by governments with weaker finances. Yet yields are at more-or-less all-time lows. Yields ‘should’ be much higher. Our governments really cannot ever hope to pay these debts back (at least, not without massively weakening their currencies). In other words, at current levels, bonds are a classic example of assets with prices that bear no relation to ‘underlying economic fundamentals’. 

But when does it all end? How long can the BoE keep expanding its balance sheet (it is now four times larger than it was in 2008)?

Paul Tustain, chief executive of online bullion dealer Bullion Vault, put out an interesting new piece of research just before Christmas – Printing Money For Beginners (And Experts).

I always enjoy Tustain’s work. As a statistician with a background in risk management and probability analysis, his outlook is sober, solidly grounded in real numbers, and therefore has a good chance of actually happening.

But bearish as I am on the UK, his latest piece made my eyes pop. He suggests that Britain might be in for some kind of monetary unravelling in the lead up to 2015. Here’s why.

Tustain most definitely thinks that government bonds are in a bubble. The key problem lies in their perceived safety.

As he puts it, “sovereign bonds are tick-the-regulatory-box collateral… This is what underpins balance sheet expansion at the central banks and everywhere else. Bond prices are behaving in exactly the way we have already seen with sub-prime properties: they are experiencing an egregious overvaluation because they alone offer a smooth passage through the form-filling of the modern regulatory environment.”

If all our financial institutions and clearing systems are holding trillions of dollars of bonds as collateral and the market suddenly does, as Tustain puts it, “grab the pricing of money back from the BoE (and it has a 100% success rate at doing this over the long term)”, then what happens?

Tustain goes on. “Interest rates would go through the roof, as they did during the bond market slump in the 70s, and in Greece just recently. Unlike the Greeks however we are unprotected by robust German opposition to printing new money to get out of the hole. Our solution will be the other way around…

“With our government unable to distribute new bonds except at punitive rates, I think it will choose the printing press over default, and it would start printing some of the £700m it needs each working day (that’s about £220m of bond repayments, and £480m of new deficit spending).

“That augurs a dramatic loss of confidence in sterling. There are simply so many bonds out there, expecting to be redeemed for cash, that it might take us close, or even in, to hyper-inflation. It is that serious”.

Could we face a sterling crisis in 2015?

But what could act as the trigger for the market to wrest back control? Tustain points to a somewhat obscure aspect of monetary economics: the Special Drawing Right (SDR). The SDR is managed by the International Monetary Fund (IMF).

It’s a kind of reserve currency made up of US dollars (41.9%), euros (37.4%), yen (9.4%) and pounds (11.3%). SDRs have in many ways replaced gold as the currency of last resort (at least as far as central banks are concerned).

Countries use SDRs to balance their foreign exchange holdings. Thailand, for example, which conducts a lot of trade with India, might hold a lot of Indian rupees, but it might not like the rupee. It can take its rupees to the Bank for International Settlements (BIS), which, as Tustain notes, ‘acts like a central bank for central banks’, and exchange them for SDRs.

While pounds remain part of the current SDR package, our currency is propped up artificially. But why an 11% weighting? The UK’s total GDP of $2.5trn is just 3.5% of gross world product of $70trn. So surely, one might argue, we should only have a 3.5% weighting?

Should that happen, the UK’s currency would no longer be propped up to the same extent. Not only that, but there would suddenly be rather a large surplus of pounds on the foreign exchange markets.

Here’s the thing: the next SDR re-setting is due in January 2015. What are the chances of things staying as they are?

Many believe that China would like the renminbi to become a reserve currency. Having an SDR weighting would be a step towards that. And given that, since the last reset in 2010, China has become the world’s largest exporter, it has a pretty irresistible case for inclusion.

And what about the European nations? Will they support our inclusion at the current weighting? Perhaps they would be keen for the UK to eat a bit of humble pie.

If the pound was suddenly given a weighting in the SDR that reflected our contribution to GWP it would no longer be propped up. Sterling’s status as a reserve currency would be shaken. There’d be an excess of pounds suddenly off-loaded. A weaker pound would cause higher inflation. In turn, that could well rattle holders of UK government bonds. And that, potentially, is a trigger for the crisis outlined by Tustain above.

All in all, this is rather grim reading for a Monday morning. I met with Tustain last week, and he gives the scenario an overall 20-25% probability. The thing to own in such circumstances is, of course, gold. But also those who fix debt at low rates stand to benefit.

For my part, I hope it doesn’t get that bad. But, put it this way, I’m not selling any of my gold. My colleagues at MoneyWeek have also recently issued a report looking at just how the vulnerable the UK economy is – if you haven’t read it yet, read it here.

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

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  • Reality Check

    Great article. I think I read something almost identical recently myself.

    One thing above does not add up though

    “It’s a kind of reserve currency made up of US dollars (66%), euros (42%), yen (12%) and pounds (11%)”

    Those percentages add up to 131%. I am pretty sure the totals have to add up to 100. So it would appear one or more of those figures are incorrect.

    Perhaps you could clarify?

  • JREwing

    Holding gold is not enough. You need to hold it outside the UK, the EU and the US. Almost all domestically held gold may end up being confiscated in the event of a currency crisis.

  • dave walsh

    And why would only the pound be forced to contribute to it’s level of GWP? Surely any re-balancing to include China would look at the other contrubutors? It’s not just the UK staring into a financial abyss in 2013

  • Roger

    Not advertisement, but Bank of China allows UK people to open account in their London branch and hold some RMB, does that make sense? If it becomes part of SDR, RMB surely will appreciate further?

  • toby

    I think your percentages – 66%, 42% etc – add up to over a 100.

  • Andrew M

    Yes the percentages are slightly incorrect, it should be: US Dollar 41.9%, Euro 37.4%, Yen 9.4%, Pound 11.3%. That adds up to 100%.

    Note that the Yen’s proportion has fallen from 18% in the late 1990s to just 9.4% today, without precipitating a currency crisis.

  • Changing Man

    According to Wiki the percentages are: US$ 41.9%, Eur 37.4%, JpY 9.4%, GBP 11.3%. As SDRs only represent about 4% of global foreign exchange assets, I can’t see that changes in the currency composition would have the degree of impact proposed in this article?

  • Chester

    Sterling devaluation is highly likely for a number of reasons, and the date range of 2015 accords with the rollover of a chunk of long dated bonds due to mature late in 2014

    Hold your gold if you have it, particularly if it was bought below $700, but it will be more profitable to hold US$ cash if you don’t. As Govts have demonstrated time and again, they resort to confiscation and capital controls when things fall apart, so geographic diversity and holding assets offshore is key

  • Orb

    Wow Dominic, with respect, you’re in the business… Either this is a shocking oversight or it is a gross misrepresentation:

    You ask “But why an 11% weighting? The UK’s total GDP … is just 3.5% of gross world product … So surely, one might argue, we should only have a 3.5% weighting?”

    In what way do you propose that 3.5% of GWP (representing ALL countries in the world surely?) should be the same as 3.5% of a basket of just 4 currencies?

    However, for the record, I was bullish the £ last year, but bearish for this.

  • Aff

    You should hold some gold, silver and bitcoins all will fair rather well over the coming years of continuing debt and currency crisis. If you can also own land.

  • omega

    SDR equals:
    0.423 euros
    12.1 yen
    0.111 pounds
    0.66 US Dollars

    This is not a % weighting. The % are approx:

    USD 42%
    EUR 37%
    GBP 11
    JPY 10%

  • NVP

    Interesting piece…….

    I gave up trying to bring “logical scenarios” to the markets a long time back and simply “trade what I see”

    Works for me most of the time …so why make Trading more difficult than it already is ?


  • Jeremy R

    This article illustrates exactly why I am far from convinced that we were as clever as we all think we were in staying out of the Euro. Sure, being in the Euro would have been hard on the UK economy, but isn’t that the point? It has enforced some discipline on countries like Ireland. True, the UK could in thoery have been just as disciplined outside of the Euro if it had chosen to be. But, as events have shown – and will show – that was never going to happen. Never has monetary policy arranged by Angela Merkel seemed more appealing

  • Andy

    You state:
    ‘…..reserve currency made up of US dollars (66%), euros (42%), yen (12%) and pounds (11%)’
    The total of the above percentages is 131%. Should it be 100%?

  • Boris MacDonut

    Maths never was Dom’s strong point. But surely MW has an editor who checks these articles. Maybe not. Following Dom’s surprise at the UK, why would the US represent 66% when it equates to 22% of the World economy? please don’t respond, I know the answer, properly described by omega at #11.
    #6 Andrew is correct . No Yen crisis in 22 years.

  • mikey

    If you want to hedge against a collapse of Sterling, why look to Gold in Dollars to do the job? Surely Gold quoted in Sterling should be the answer? (Although admittedly, that’s increasing the risk of appropriation – you just have to time the buying and then selling rather carefully … )

  • Peter Cooper

    Japan and the UK look the most vulnerable to currency devaluation thanks to their central banks printing money like crazy to inflate away the largest debts in the world – and you can have a big argument about which of these major countries is most in debt but there is no doubt it is a choice between these two.

  • Moderator

    Thanks all for pointing out the ropey arithmetic. We’ve put the correct figures in now.