Could this be the trigger for a sterling crisis?
Dominic Frisby Jan 14, 2013
'Bubble' is one of those terms that gets bandied about rather liberally, with no one quite agreeing on what it means.
Some say it's merely a rapid price rise, with a contraction to follow. Others say it's a rapid price increase, which bears no relation to underlying economic fundamentals. This creates an artificial market, meaning that rapid drops are inevitable.
I like to define a bubble as “a bull market in which you don't have a position”.
All three of these definitions could easily be applied to the US long bond (the 30-year Treasury) and UK gilts. So are these governments bonds in a bubble? And if so, when will it pop? And what will the consequences be?
Government bonds are just like the sub-prime bubble
One thing about bubbles is that they tend to catch people unawares. There are a few canny souls who see them for what they are, but plenty get caught with their trousers down. So many people have already labelled UK and US sovereign debt as being in a bubble, that you wonder if any bad news is already ‘priced in’.
Yet, on the other hand, there are millions caught up in this sovereign debt 'bubble', many of them unwittingly. Almost all large institutions, from pension funds to hedge funds, high street banks and global investment banks, own large quantities of government bonds. They have to. No investment better ticks the regulatory boxes.
And statistic after statistic makes you shake your head and say: “this isn't for real”. The Bank of England has bought about 50% of UK government debt issued since 2009. It now owns something like 30-35% of all existing UK government debt.
There are all sorts of justifications put about for the BoE doing this. Most boil down to the perception that if it doesn’t, everything will fall apart. But there can be no doubt that this is an ‘artificial market’.
Bonds have rarely been issued by governments with weaker finances. Yet yields are at more-or-less all-time lows. Yields ‘should’ be much higher. Our governments really cannot ever hope to pay these debts back (at least, not without massively weakening their currencies). In other words, at current levels, bonds are a classic example of assets with prices that bear no relation to 'underlying economic fundamentals'.
But when does it all end? How long can the BoE keep expanding its balance sheet (it is now four times larger than it was in 2008)?
Paul Tustain, chief executive of online bullion dealer Bullion Vault, put out an interesting new piece of research just before Christmas – Printing Money For Beginners (And Experts).
I always enjoy Tustain’s work. As a statistician with a background in risk management and probability analysis, his outlook is sober, solidly grounded in real numbers, and therefore has a good chance of actually happening.
But bearish as I am on the UK, his latest piece made my eyes pop. He suggests that Britain might be in for some kind of monetary unravelling in the lead up to 2015. Here's why.
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Tustain most definitely thinks that government bonds are in a bubble. The key problem lies in their perceived safety.
As he puts it, “sovereign bonds are tick-the-regulatory-box collateral… This is what underpins balance sheet expansion at the central banks and everywhere else. Bond prices are behaving in exactly the way we have already seen with sub-prime properties: they are experiencing an egregious overvaluation because they alone offer a smooth passage through the form-filling of the modern regulatory environment.”
If all our financial institutions and clearing systems are holding trillions of dollars of bonds as collateral and the market suddenly does, as Tustain puts it, “grab the pricing of money back from the BoE (and it has a 100% success rate at doing this over the long term)”, then what happens?
Tustain goes on. “Interest rates would go through the roof, as they did during the bond market slump in the 70s, and in Greece just recently. Unlike the Greeks however we are unprotected by robust German opposition to printing new money to get out of the hole. Our solution will be the other way around…
“With our government unable to distribute new bonds except at punitive rates, I think it will choose the printing press over default, and it would start printing some of the £700m it needs each working day (that's about £220m of bond repayments, and £480m of new deficit spending).
“That augurs a dramatic loss of confidence in sterling. There are simply so many bonds out there, expecting to be redeemed for cash, that it might take us close, or even in, to hyper-inflation. It is that serious”.
Could we face a sterling crisis in 2015?
But what could act as the trigger for the market to wrest back control? Tustain points to a somewhat obscure aspect of monetary economics: the Special Drawing Right (SDR). The SDR is managed by the International Monetary Fund (IMF).
It’s a kind of reserve currency made up of US dollars (41.9%), euros (37.4%), yen (9.4%) and pounds (11.3%). SDRs have in many ways replaced gold as the currency of last resort (at least as far as central banks are concerned).
Countries use SDRs to balance their foreign exchange holdings. Thailand, for example, which conducts a lot of trade with India, might hold a lot of Indian rupees, but it might not like the rupee. It can take its rupees to the Bank for International Settlements (BIS), which, as Tustain notes, 'acts like a central bank for central banks', and exchange them for SDRs.
While pounds remain part of the current SDR package, our currency is propped up artificially. But why an 11% weighting? The UK’s total GDP of $2.5trn is just 3.5% of gross world product of $70trn. So surely, one might argue, we should only have a 3.5% weighting?
Should that happen, the UK’s currency would no longer be propped up to the same extent. Not only that, but there would suddenly be rather a large surplus of pounds on the foreign exchange markets.
Here’s the thing: the next SDR re-setting is due in January 2015. What are the chances of things staying as they are?
Many believe that China would like the renminbi to become a reserve currency. Having an SDR weighting would be a step towards that. And given that, since the last reset in 2010, China has become the world’s largest exporter, it has a pretty irresistible case for inclusion.
And what about the European nations? Will they support our inclusion at the current weighting? Perhaps they would be keen for the UK to eat a bit of humble pie.
If the pound was suddenly given a weighting in the SDR that reflected our contribution to GWP it would no longer be propped up. Sterling’s status as a reserve currency would be shaken. There'd be an excess of pounds suddenly off-loaded. A weaker pound would cause higher inflation. In turn, that could well rattle holders of UK government bonds. And that, potentially, is a trigger for the crisis outlined by Tustain above.
All in all, this is rather grim reading for a Monday morning. I met with Tustain last week, and he gives the scenario an overall 20-25% probability. The thing to own in such circumstances is, of course, gold. But also those who fix debt at low rates stand to benefit.
For my part, I hope it doesn’t get that bad. But, put it this way, I’m not selling any of my gold. My colleagues at MoneyWeek have also recently issued a report looking at just how the vulnerable the UK economy is – if you haven’t read it yet, read it here.
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