Pimco's Bill Gross, manager of the world's largest bond fund, recently warned investors to avoid UK government bonds, saying that gilts were "resting on a bed of nitroglycerine". Is he right? Here, two of MoneyWeek's experts, James Ferguson and Tim Price, look at the case for and against gilts.
No. He's just talking his book
James Ferguson
When the world's biggest bond investor warns against buying a specific country's government debt, people take notice unsurprisingly. Bill Gross is wary of Britain's "high debt with the potential to devalue currency".
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It's a nightmare scenario for foreign bond-holders. But I suspect Gross's motives. He has to send the crowd a different way in order to take bets, which by their nature for him must be contrarian at the time (because it takes so long to switch his funds' huge positions). If Britain continues on its current course, gilts might blow up. But the situation is fluid. At least four factors complicate the fairly 'obvious' bear case.
1. The election
Whoever wins, the post-election world will look very different. Public-sector employment will fall as sliding tax revenues hammer local governments and the central government refuses to bail them out. Spending will be cut and taxes will rise further. We have until June at the latest before the brakes are slammed on (and most likely the economy slips back into recession in 12 months' time).
Gross's favourite government bonds are those of Canada and Germany. Both have a higher total public-sector debt to GDP ratio than Britain does. The reasons he fears the UK are the high proportion of private-sector debt and the high public-sector deficit (the gap between current spending and current income), of around 12% of GDP. But if Britain was to cut spending after the election, so that the deficit fell to 5% of GDP, it would look healthier than Canada. Markets tend to follow the second derivative they like improvement and sell deterioration. If the UK deficit falls, even if it's not as far as 5%, that could be very bullish for gilts.
2. Banks are buying gilts
Having run a small net short for the last few years, UK banks have bought a net £280bn of (almost entirely short-dated) gilts in the last five quarters. That's bigger than the Bank of England's (BoE) quantitative easing programme (QE) by almost half again and equal to 20% of GDP. The game has shifted and even the Treasury's Debt Management Office hasn't cottoned on yet. For all the talk of impending new bubbles, there is a genuinely explosive bubble out there already that no one has spotted yet: short-dated, developed-world government debt. The UK six-month gilt yielded 5.7% in October 2007, just as the crisis first kicked off. Now it's 0.57%. Even more extreme: US three-month Treasury yields went below zero again prior to Christmas. But while banks are buying, short-dated gilt yields are highly unlikely to rise and such deleveraging episodes tend to last five years or more.
3. Sterling has already collapsed
What about the risk to foreigners of a collapse in sterling? We can't stop foreign holders of long-dated gilts from selling. And now the BoE has wound down QE, where will the buyers come from? Fair questions. But it's not so easy to see which currency sterling would collapse against. The pound has already had its crisis. It fell 31% in 18 months after the financial crisis began. Yet since people started talking about the downside risks in early 2009, sterling has in fact risen 10%.
4. And who says QE is finished?
If you look at M4 lending (the usual conduit for boosting broad money growth) it seems Britain's money supply might have shrunk by 5% if it hadn't been for QE. That would be real, proper deflationary recession territory. If (when) things turn nasty again, as the politicians slash spending to tackle the deficit after the election, QE will have to come back. Without export growth, a private-sector credit recovery or debt-funded fiscal expansion, there isn't much else to do.
So, bizarrely, although it looks 'certain' that the UK deficit will spiral out of control, the reality may be different. The better the economic data and the firmer inflation looks in the pre-election run-up, the greater the risk of a fiscal-restraint-induced double-dip as we go into year-end. The worse the deficit, the harsher the fiscal cut-backs will be, and the harder the economy will be hit. And the harder the economy is hit, the stronger the demand for gilts. One thing's for sure: markets are about to get extremely volatile.
For more from James, read Model Investor. Call 020-7633 3620, or see www.moneyweek.com/newsletters.aspx .
Yes. How could anyone quibble?
Tim Price
Bill Gross has a reputation for blunt speaking on investment. But his 'nitroglycerine' comment is, even for him, racy by the standards of the normally placid bond market. So is he right? I think he probably is.
Gross highlights the painfully high level of UK government debt and the threat of a further devalued sterling. I don't see how any open-minded, objective investor could quibble with these views. Conventional wisdom and traditional investor preference has it that developed governments simply don't default. As democratic Western governments have tax-raising powers and control of the currency printing press, this is narrowly true. But it avoids the simple fact that dramatic currency depreciation and a generalised rise in inflation amount to debt repudiation in all but name.
The argument is nuanced, though, because we are in an extraordinary financial environment. It's unclear just how the current tug-of-war within the credit markets will be won. On the one hand, the supply of gilts is exploding, Britain's credit fundamentals are deteriorating sharply, and a formal debt downgrade from our current 'AAA' status may be only a matter of time. So the fundamentals are unequivocally negative.
On the other hand, I have some sympathy with the deflationists' cause. Regardless of the general election outcome, we will see ongoing deleveraging by the private sector. The only question is, will the next government join in? Or will it simply allow public spending and the gilt market to explode? I also understand the arguments that British banks will be ongoing buyers of gilts. But just because banks may be forced to buy certain assets for largely regulatory reasons, that does not make them attractive investments for the rest of us, who have effectively almost infinite choice.
And Gross is undeniably correct to highlight the growing downside risks in owning gilts now, whatever his motives. 2009 may have been the year in which the financial system was saved. But 2010 is the year when we ask: at what cost?An endless Keynesian response to the banking crisis and a potential double-dip back into recession will at some point run into the remorseless logic of the Austrian economic school.
This holds, in the ominous words of Ludwig von Mises, that "there is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion [of which there is no sign under the current monetary authorities], or later as a final and total catastrophe of the currency system involved." Sterling is the canary in the coal mine, having devalued by roughly 25% against the US dollar during the last two-and-a-half years.
What makes the outlook for gilts so confused is that the playing field has been made unstable by political intervention. Gilt prices have been manipulated by central bank buying. Those artificially suppressed yields have, in turn, affected the prices of all other risk assets. When politics rather than fundamentals dictate returns, how can we be remotely sure of the outcome? But sometimes the smartest move in the investment game is not to play. If your arguments for owning a given asset rest largely on a variation of 'greater fool theory' (the banks will be buying, therefore so should you), it strikes me that there must surely be investments out there with a better risk/reward profile.
Whatever the near-term returns, the political and credit risks of owning gilts have risen sharply since the start of the crisis. The supply of gilts is rising while the underlying credit quality is falling. There are fundamentally more attractive investments, and government bonds, elsewhere.
Tim Price is director of investment at PFP Wealth Management. He writes The Price Report newsletter (see www.moneyweek.com/newsletters.aspx , or call 020-7633 3637).
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