Osbo’s Gilt Complex

STATUTORY WARNING: This blog is calibrated for fiscal anoraks and may cause nausea and/or disorientation among those faint-hearted about figures.

This year has not started well for George Osborne. While some might relish the evil schadenfreude in that, the problem is the corollary means this year has started badly for the British punter, with today’s stark news that GDP fell in the fourth quarter of 2012 (by 0.3%)—making the only quarter for over a year when our finances were not declining was during London’s Olympics.

The bottom line on this, reinforced by some pretty stern comments from the IMF, is that the present financial (and abrasive) Plan ‘A’ for the economy, in place since May 2010, is itself bankrupt. After £385 bn of ‘quantative easing’ where the Treasury simply prints the money it needs and most of those 2 1/2 years with bank interest rates in the tank (0.5% has been typical), all we are getting from our economic engine is the ‘rurr-rurr-rurr’ of the starter motor flattening the battery. But firing is there none.

In comments that will be seen as a strong criticism of the Bank of England’s quantitative easing policy, Lord Turner (currently FSA chair but one of the leading candidates to replace Sir Mervyn King at the Bank of England) said printing more money would have a declining marginal impact and would threaten the stability of the economy. As he elaborated:

“Quantitative easing has left Britain facing a liquidity trap in which replacing private sector holdings of bonds with private sector holdings of money has little impact on behaviour and thus on demand”.

In December, Osborne & his Treasury mandarins hit on the alternative wheeze of so-called ‘perpetual bonds’ to cut the cost of the UK’s borrowing, by increasing the terms of long-dated bonds from the current average of 30 years. The last undated gilt was issued in October 1946, shortly after the end of World War Two. The Chancellor hoped to leverage the Government’s ability to borrow money at the cheapest rate in the 400-year history of the Treasury.

“This reflects the confidence investors have in Britain’s ability to pay its way,” said Mr Osborne during his budget speech in March.

The Debt Management Office (DMO) has now confirmed that this ambitious plan has been dropped. The admission follows an industry consultation during the summer to which investors including Hermes, the Association of British Insurers and Goldman Sachs all responded. An unimpressed DMO said “In the case of perpetual gilts, the Government judges that these would be unlikely to represent a cost effective source of financing at present in the absence of tangible market demand”.

Whereas this time last year, Osborne forecast 2.8% growth for 2012, the real number is 0%. Given that 75% of the UK economy is now services and that has been flat, this is scarcely surprising. But he’s getting ALL his figures wrong. His Plan ‘A’  assumed 6% total growth by now: the real number is 0.6%.

The Office for National Statistics said that public sector net borrowing rose last month to £15.4bn from £14.8bn a year earlier, as spending grew faster than income in a struggling economy, thwarting efforts to erase a large budget deficit. Government borrowing amounted to £106.5bn in the first nine months of financial year 2012/13—7.3% higher than the £99.3bn in the corresponding period in 2011/12. Put another way, we’re in a hole and we’re still digging.

As anyone with personal debt out of control will tell you, it becomes an ever-more frenetic race just to keep financing everyday life. In many ways, Osborne (and, believe it or not, the public) has had it easy up to now. Between QE, low interest rates and a continued AAA rating, the growing UK debt has placed very little burden on the government’s cash flow. Yet. It’s as if you’re badly in debt but mortgage rates are tiny, the bank is charging you insanely low interest on your overdraft and your dad keeps slipping you £100 a week on the side.

It won’t last.

Firstly, Osborne’s toolbox is empty. He went easy on the banks, didn’t force them to lend, nor to clamp down on bonuses. They rewarded him by out-scrooge-ing Scrooge on loans. He eased up taxing the super-rich and multinationals, rationalising that their liquidity would boost the economy. They rewarded him by shoveling as much income offshore as they could and paying minimal, if not negligible, taxes.

Secondly, even the global appetite for UK Treasury bonds (known as ‘Gilts’ because they are—supposedly—a gilt-edge security that cannot lose value) is showing limits. It’s easy to see why so many investors are pouring their money into government bonds. Ever since the credit bubble burst, investors are wary of the risks posed by stocks. Over the past decade, bonds gave the safe return they were looking for.

UKgilts

Demand (not least from the Bank of England mopping things up) has driven Gilt prices up so much that they are at an all-time high, meaning yields are at rock bottom levels. 10 year Gilts, for example, yield just 3%—less than the rate of inflation. Robert Froehlich, senior managing director of the Hartford Financial Services Group says “The bond market is a bubble and it’s getting ready to burst.” Asked whether government bonds currently represent fair value, 72% of CFAs (Chartered Financial Analysts) believe they are somewhat or very overvalued, compared to only 12% who view them as somewhat or very undervalued.

So…what happens if (when?) investors decide the Emperor indeed has no clothes and the market, herd-like as ever, stampedes for the exits from Gilts? Prices drop, yields go up and it becomes ever harder for the Treasury to unload its paper. Such a crisis of confidence would damage the UK as a stable financial centre. The AAA credit rating would be history—even holding on to an AA would be doubtful.

That triggers a vicious spiral as yields rise trying to make Gilts more attractive, but borrowing the same amount of money now costs more and UK ability to repay that onerous debt is thrown into even deeper doubt. At that point, there is a run on the pound as the Masters of the Universe down Canary Wharf way mobilise investment billions to profit from its slide. Eminence grise from the 1992 ERM debacle George Soros may now be in retirement but said recently “investors are now betting against the pound”. The embarassment of a devaluation would be the least of it.

Some people think this would be good because it means our exports look cheaper to others and so we would have a boom as they buy more. In the days of shipbuilding and good ol’ British engineering, that might have been an argument. But with 75% of our economy now services, there are only so many Indian-owned Jaguars we can sell overseas. Meanwhile, every TV, microwave, computer, out-of-season fruit, Cyprus holiday, etc will cost more, gobbling up even more of frozen wage packets.

Only we won’t notice that because the mortgage rates will also have risen, house prices stagnated and credit card debt become unsustainable as interest rates rise. Not everyone will be so badly affected. Ironically, the Scots—beside their robust oil industry—have seen a £1.6bn increase in exports to a record £23.9bn and, at the same time, exporting £45.5bn to the rest of the UK. None of those figures include our £7.6bn oil export overseas (4.5% growth). Since the export figures for the entire UK dropped 4.8% during 2012, that must mean England’s exports dropped even more than that. Certainly, devaluing the pound alone is no ‘silver bullet’ solution.

Rather than stuff it down your throat, gentle reader. I will leave you to draw your own political conclusions from this. But should you want my advice, buy gold (ScotGold shares trade on the AIM market—disclosure: I am long ScotGold) and vote #indy.

About davidsberry

Local councillor, tour guide and database designer. Keen on wildlife, history, boats and music. Stood for the Scottish Parliament 2011; lost by 151 votes.
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