I said in last week’s letter that investors should avoid gilts, what with the market being at the mercy of flip-flopping by the government and the Bank of England. But I didn’t expect the downside to be revealed so rapidly.
First we had Tuesday’s ‘shock’ inflation figures. Not only did the dreaded deflation fail to make an appearance, but in fact, the inflation rate went up. This shouldn’t have come as much of a surprise really. The main thing falling in price is the cost of servicing debt – which is why the Retail Price Index, which includes mortgage costs, fell. On the other hand, the collapsing pound has driven up the cost of everything we import – hence the rise in the Consumer Price Index, which doesn’t include mortgage costs. Great news if you’ve got a variable rate mortgage, bad news if you like eating or turning your heating on occasionally.
The figures rattled all those people who’d been piling into UK government debt as a sure-fire defence against falling prices. And worse was to come. The next day, Bank of England Governor Mervyn King warned Gordon Brown that Britain simply can’t afford another big stimulus package, poking a major hole in the prime minister’s credibility before both the G20 summit and the budget next month. More importantly, he added that the Bank might not end up spending the whole £75bn it has available for buying gilts if the inflation figures keep going the way they are.
Needless to say, the idea that the Bank wouldn’t be snapping up as many gilts as expected sent yields up sharply. Now it looks as though the number of investors willing to lend to the government is already drying right up. After all, if the Bank of England won’t buy this rubbish, why should they?
On Wednesday, Britain suffered its first gilt auction failure since 2002. The government tried to flog off £1.75bn of 40-year gilts. Investors only put in bids worth £1.63bn. That doesn’t bode well, given that the government is planning to sell a record £146.4bn of debt between now and next April. What happens if Britain can’t attract enough investors to fund its spending plans? Well, as one commentator told newswire Bloomberg, Brown’s “whole strategy is based on borrowing”. If no one’s in the market for gilts, then “the prospect of going cap in hand to the International Monetary Fund hovers increasingly into view”. That won’t be much fun, given that we’ll be in the queue behind half of eastern Europe.
Perhaps Federal Reserve chief Ben Bernanke should have waited a bit longer before he decided to copy the Bank of England and pile into the US Treasuries market. He may yet live to regret it.