Ditch gilts and get out of sterling: Britain is heading for trouble

Here's what the next few years hold in store for the average British worker.

Your cost of living is going to keep rising. Your income will not keep up. So each and every year, you're going to get a little bit poorer.

Meanwhile, what little savings you can scrape together will be shedding value too. Because interest rates on savings won't be going anywhere.

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In fact, they might even fall, because banks can get all the cheap money they want from the government, as long as they pass on a bit of it to homeowners who want to refinance their mortgages.

To cap it all, even if you can afford to go on holiday, your pounds won't go very far when you get there.

Pretty miserable, eh? And that's not me talking that's the message from the Bank of England itself...

The Bank of England has thrown in the towel

Yesterday's Bank of England inflation report was a bit of a bombshell.

The Bank has hardly been a non-stop source of uplifting news in the past few years. But yesterday's report just sounded like it was throwing in the towel. And that's the key point to take away.

The Bank has been terrible at forecasting inflation in recent years. But normally it at least tries to pretend that it will hit its target. Somehow, our current "temporary" (it's always "temporary") inflation is always going to be under control within the next two years. Therefore, there's no need to raise interest rates to bring it in line.

Now it's dropped the pretence. Inflation is currently at 2.7% on the Bank's target Consumer Prices Index (CPI) measure. It's going to rise above 3% this year, and remain above 2% until 2016.

And bear in mind the Bank has a consistent track record of underestimating inflation. This is probably semi-deliberate. I'm not trying to spawn conspiracy theories here. Part of a central bank's job in controlling inflation is to keep people's expectations down, as this can become a self-feeding spiral. So the Bank will have a natural bias towards keeping a lid on bad news about rising prices.

In short, our central bank has just told us that inflation is going to be higher than anyone had hoped for a prolonged period of time. And it's not going to do anything about it.

That's quite a serious shift. And markets are already waking up to it. The most obvious casualty was the pound, which slid against the euro and the US dollar. As Jason Conibear at currency group Cambridge Mercantile told ThisisMoney.co.uk: "Confidence in the pound was already thin. The governor's admission that the inflation target is to be quietly ignored while the economy remains in intensive care has stretched it even further."

You see, in more normal times, higher-than-expected inflation would boost the currency, because traders would expect higher interest rates to follow. But if the central bank decides it's not going to tighten policy, then it's a green light to dump the currency.

More worrying still is what's happening in the gilts market. As James Mackintosh notes in the FT, the bond market's "best guess" at inflation over the next ten years "has jumped this year". It's now near its highest level since the financial crisis. The ten-year gilt yield is now around 2.2%, and seems to have bottomed out in August last year (in fact, around about the time we published this bond market debate between Tim Price and James Ferguson).

Keep an eye on gilt yields

It's no surprise investors are getting jittery. The Bank won't raise rates because economic growth is going to be weak. But if real' wages (adjusted for inflation) keep falling, it's hard to see where the growth is going to come from. The only goal left is to drive inflation higher and inflate away our debts.

But if that's the plan, then why would anyone lend money to the UK at current interest rates? You're just going to lose money.

This is a potentially serious problem. Keith Wade and Jamie Bilson at Schroders calculate that the UK government needs to borrow another £440bn by issuing gilts between now and April 2017. That's being optimistic about it (which Schroders acknowledge). In short, "there is a sizeable wave of issuance on the horizon".

Now, we all know that the gilt market isn't what it used to be. The Bank of England used to own precisely no gilts. Now, via quantitative easing (QE), it owns £350bn (and has more to buy). That's more than a quarter of the market. More importantly, it's nearly half of the £800bn the government has issued since December 2007.

So who's going to buy the next £440bn? The Bank of England might pick up some of it, but it can't foot the bill for the lot.

Much of this is a question of confidence and perception. The idea behind QE is that it's meant to spur growth by persuading investors to take more risks. It's not there to give the government a way to fund itself at cheap rates.

What worries me is this. What happens if inflation goes a lot higher than the Bank of England expects? It got up to nearly 6% on the retail prices index in September 2011, for example. That's when it starts to creep into newspaper headlines.

The Bank won't be in a position to raise rates. But how many gilt investors will put up with that? The risk is that existing gilt holders start to sell, and drive yields higher. If at any point it looks as though the Bank is being forced to step in to do more QE, simply because no one else wants to buy gilts, that would be a disaster.

The government would likely try all sorts of things to prevent that from happening. Financial repression forcing pension funds or banks to hold more gilts is one method. But those sorts of moves won't inspire confidence in the UK either.

It might seem a scary prospect but far stranger things have happened. I've been racking my brains and there's still not a single major currency I'd feel comfortable taking a long bet on sterling against.

What does it all mean for you?

It goes without saying that we wouldn't own gilts here. And we've already pointed out that you need to diversify your portfolio away from sterling: invest globally, and own some gold as insurance. We looked at how to do this in more detail in our recent currency wars cover story.

I suspect this is going to become a much bigger issue in the year ahead.

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

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