A warning from the bond markets
Dec 07, 2009
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Morgan Stanley has warned of a potential UK sovereign debt crisis that could lead to severe pound weakness and a sell-off in UK government bonds. They said, that the Bank of England may be forced to hike rates to shore up confidence in monetary policy.
Prior to that, on Monday 23 November, Gillian Tett posed the question in the FT: 'Will sovereign debt be the new subprime?' Quoting in her article that Claudio Borio, head of research at the Bank for International Settlements warned that "As policymakers rush to implement reforms in response to one financial calamity, they are apt to create distortions that pave the way for the next disaster".
Needless to say, if Morgan Stanley are right and the Bank of England is forced to panic into prematurely increasing short-term rates and if gilt yields rise, the scale of the crisis would magnify and significantly damage asset prices. The one thing the Bank of England doesn't need is for monetary policy to be imposed upon it.
In Gillian Tett's article, she says "That does not necessarily mean an outright default looms any time soon; indeed, default seems highly unlikely. However, it is easy to imagine that some countries will end up eroding the value of their bonds by debasing their currencies in the coming years, printing money and stoking inflation."
We have long said that inflation is unlikely unless economic recovery gains momentum. In our view there are serious reasons to doubt the validity of a V-shaped recovery.
Quite clearly, we are approaching a day of reckoning when the truth will be more obvious. It seems more likely to us that the economy is on the brink of great disappointment, if not disaster. The good news is that uncertainty will soon end. But what will follow? Will it be inflation, rising prices and rising wages? We think that is most unlikely. Stagflation, a recession with rising prices? Although possible, we think very unlikely. We don't see how prices (and wages) will rise in an ongoing recession. Deflation? We think this is more likely - the outcome of a failed stock market rally and return to bear market conditions.
Deflation would be the equivalent of 'shock and awe', triggering an end to any nascent housing and stock market recovery and killing consumer spending.
Of late and rather surprisingly given the strength of stock markets, the US two-year Treasury Yield has fallen almost to its low of late 2009, not far above zero. The conclusion one can draw from this is that the bond markets see a whole different future than the stock markets. The savviest investors are those who work in the bond market and not those who work in the equity market. Their message for next year is "watch out".
• This article was written by Full Circle Asset Management, and was published in the threesixty Newsletter on 4 December 2009.
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