Why you should be buying bonds now
Sep 02, 2008
The government is likely to issue up to £100m in gilts in the next financial year.
The dialogue continues. On the one hand, declining asset values, the credit contraction and growing unemployment are individually and collectively deflationary, whilst on the other hand higher food and oil prices are inflationary. Another very important ingredient is job security, without which wage pressures will be modest. Without spiralling wages, inflation gains no traction and could be expunged simply by oil and food pressures remaining high, but not going higher.
According to the Daily Telegraph on 17th August, this could happen to such an extent that some economists say that next year inflation could fall below 1%. Levels of inflation could fall next year if oil and food prices only go sideways, particularly if wages become moribund and unemployment rises, both, we think, are almost certain.
The long end of the UK gilt market remains buoyant, index-linkers are positively exuberant. Many presume that buyers are mad because with inflation so high why would they buy conventional gilts yielding less than 4.25% until 2055. There are two possible reasons. Either a flight to quality away from conventional assets, such as equities and property - and there is a lot of that happening. Or because they believe inflation is set to go much lower soon. We are buyers for both reasons.
The threat to gilts comes from more supply. It is quite obvious that Alistair Darling is going to struggle as government revenue falls on the back of a lower tax take. According to Angela Monaghan in the Daily Telegraph, they may have to issue £100 billion in gilts in the next fiscal year. Not only does she say the tax revenues are going to be less, but there will be the added burden of more to spend on unemployment benefits.
If, as we believe, the economy is in big trouble and asset prices decline, as we think they will, then the growing demand from pension funds and long term investors ought to be sufficient to mop that up.
• Three-month dollar, sterling and euro interest rates remain dramatically higher than official rates. The willingness of banks to trust each other has not improved. Currently, dollar three-month money is 90 basis points above the official rate, sterling three-month money is 70 basis points above UK base rate and euro three-month money is 60 basis points above the ECB official rate. Historically, three-month money has varied only modestly from official rates. Going forwards therefore it is likely that any change in this interest rate discrepancy might be an important signal.
• This article was written by John Robson & Andrew Selsby at Full Circle Asset Management, as published in the threesixty Newsletter
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