Protect yourself from an exploding gilt bubble

published 3 July 2012

Back in January 2010, US bond investor Bill Gross warned that UK gilts were "resting on a bed of nitro-glycerine". He said the country was a "must to avoid".

Since then, the yield on the ten-year gilt has dropped from 3.7% to around 1.7%. In other words, the price has risen. Anyone invested in gilts made money. Even the exchange rate hasn't shifted much.

Cue much cheering at Gross's expense. No one likes foreigners poking their noses into their country's business, particularly ahead of an election.

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But I wouldn't get too excited. The fact is, Gross was right. If anything, the fall in yields has merely added more explosive to the mix.

And just because it hasn't gone off yet, doesn't mean that it won't

Britain's charms are fleeting

Why have gilts proved so popular? Britain has three key attractions as a safe haven. Firstly, it's not in the eurozone. Secondly, it has a central bank that is willing to print money to buy gilts. Thirdly, it has a government that talks tough on spending even although it hasn't actually done anything radical.

None of those things strike me as being indicative of an incredibly sturdy economy. And I'm not the only one.

Some recently published reports from Hinde Capital note that, if anything, Britain has become more vulnerable to shocks since the financial crisis. And once again, much of the danger is centred around the UK housing market.

As the reports note, house prices remain 12% below the peak at the financial crisis (obviously this varies widely across the country). But they've seen a bounce since 2009. Indeed, the UK "is the only main housing market to have had any sustained bounce".

This was down to the Bank of England slashing interest rates, which helped those on tracker mortgages to keep paying their bills. The problem is that, following the crisis, more and more houses have moved from fixed-rate loans to variable or tracker-rate loans.

In fact, fixed-rate loans now account for "less than 30% of mortgages" from more than half (by outstanding balance) before the crisis. This is partly because people are having difficulty remortgaging, so they end up on the lender's standard variable rate (SVR).

All of this means that the housing market is much more sensitive to any shift in interest rates. And because rates are so low, it doesn't take much of a move to make a significant difference in the size of someone's payments.

In all, this leaves "UK property vulnerable to another correction". This is all quite similar to the argument we've made in our latest property report if you haven't had a chance to look at this yet, you can find out more here.

The danger here is that any downturn in the property market would hurt the banks. And that's where we get back to the question of the gilt market. One of the big problems for troubled eurozone nations has been the bank-sovereign-bank doom loop', as it's been nicknamed.

Banks hold big chunks of their own government's debt because it's deemed risk free. But then markets get worried that the government will have to stand behind these bankrupt banks. Suddenly the sovereign debt no longer looks risk free. It falls in value. As a result, the banks' balance sheets look even worse.

That increases fears that they'll need to be bailed out by the government, which again, hits the value of the sovereign debt, and so on, until the whole thing blows up.

So what? You might argue that the Bank of England will just print more money, which the European Central Bank has so far proved unwilling to do. And in fact, there's every chance that there will be more money-printing by the end of this week. But if there's one thing that we can say about quantitative easing (QE), it's that it hurts a nation's currency.

More QE equals a weaker pound. And if you're a foreign investor who doesn't want to get repaid in devalued pounds, you're not going to be keen to hold onto UK gilts. Says Hinde: "Foreign investors would want to be compensated for inflation and default risks with both lower sterling values and higher bond rates."

Rising bond rates would feed through to borrowing costs across the rest of the economy, setting up our very own doom loop'. Falling prices in both the housing market and the gilts market would hit banks' balance sheets.

What you should do to protect yourself

Timing these things is difficult, if not impossible. But the point is that Britain's safe haven' status is predicated on a stream of crises happening elsewhere. Britain is not fundamentally a safe' destination for capital. It's just one of the least bad' for now.

That won't last. And it wouldn't necessarily take much for sentiment to start turning against the UK anything from an improvement in sentiment towards the eurozone, to a realisation that neither growth nor public borrowing targets will be met. So while we wouldn't short them, we'd certainly keep avoiding gilts (except index-linkers, if you already hold them). And you guessed it you should hang on to goldto protect yourself from any slide in sterling.

In the next issue of MoneyWeek magazine, we'll also be looking at the outlook for the financial industry, and Britain as a whole, in the wake of the latest banking scandals. More importantly, we'll be spelling out just what it means for your money. If you're not already a subscriber, you can subscribe to MoneyWeek magazine.

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

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John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.