Is Britain sliding towards hyperinflation?
By
Dominic Frisby Mar 03, 2010
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Greece was upstaged yesterday afternoon as another nation stepped into the sovereign debt crisis spotlight. This time it's Ukraine grabbing the headlines.
Ukraine's economy shrunk by some 15% last year. The country was loaned $16.4bn by the International Monetary Fund (IMF), but the funds have effectively been frozen since November, due to political turmoil.
Last month's disputed election led to a court challenge, while the 2010 budget has been hindered by legislative fighting. Today, Prime Minister Yulia Tymoshenko and her cabinet were dismissed after a no-confidence vote by parliament, leaving newly-elected president Viktor Yanukovych with the tricky task of forming a new coalition government.
That's a shame for the Ukrainians, you might be thinking. But what's it got to do with us? Plenty. Ukraine's plight offers a grim warning for the UK – here's why...
It's no wonder forex markets have got the jitters
A political overhaul may bring some much-needed stability back to Ukraine. But for now, the country is struggling to raise enough money in financial markets to service its foreign and domestic debt. Yesterday's attempt to raise money by issuing three-year domestic bonds saw yields rise to 22.92%. That is a staggering number.
So it's no wonder that the foreign exchange (forex) markets have got the jitters about the impact of a hung parliament in the UK on sterling. Here's an updated version of the chart I posted a few weeks back of sterling vs the US dollar. We have broken down through that channel (the blue lines on the chart) with alarming violence.
For now we seem to be finding support at the $1.49 area. I would urge you, if you don't already have any foreign currency exposure or gold, to take advantage of any bounce we see in the coming weeks – and we should get one – to move some assets out of sterling and hedge yourselves.
Looking at a longer-term chart since 1991, there's a lot of support at $1.45 and at just below $1.40. But a re-test of last year's lows looks fairly inevitable at some stage this year.
A move below last year's lows around $1.35 would be very serious. Given the chart action of the past 20 years, it's most unlikely. But I would not rule it out. The speed and violence of this last month's move down suggests that Gordon Brown's chickens – the consequences of excess UK debt – may now be coming home to roost.
Britain's road to hyperinflation
This reminds me of a flow chart published by the trader Michael Hampton last year on his website globaledgeinvestors.com. You can see it below. It describes the US, but it also applies here in the UK.
A word of warning: when I first saw it my initial instinct was to jump on the first train out of Dodge, so to speak, and head for the hills. But don't panic. Yes, it predicts a depression, or severe recession at least. But it does not point to Armageddon. Despite the connotations of the word depression and the fears associated with it, it is in fact not an abnormal part of the business cycle. As long as you are prepared, you can protect your wealth. And there's no guarantee, of course, it will actually play out this way. Take a look at it, and I'll explain the steps in more detail below.
The chart makes many of the same arguments we've made in the past. After the dotcom bust, Alan Greenspan slashed US interest rates and other central banks followed. This led to reckless lending and malinvestment; we saw bubbles in numerous assets, particularly housing. That takes us from step one to step four.
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As stages five to seven depict, the bursting credit bubble led to huge losses for the banks in 2007-8. The banks were bailed out, interest rates were slashed further, and central banks used quantitative easing, or money printing, to tackle collapsing credit availability. The banks' toxic assets have effectively been transferred onto the balance sheets of governments.
The UK now sits somewhere between steps eight, nine and ten. We are vulnerable to higher rates (step eight). Gilt yields are slowly rising as our creditors start to get the jitters (step nine). And we are starting to see a weaker pound (step ten).
If this process continues – and a break below $1.35 on the US dollar index will tell us the process is accelerating – then the next phase of much-weakened sterling will mean considerably higher costs on imported goods, particularly commodities. The resulting higher inflation rates will have to force interest rates up eventually. This leads to steps 12 and 13, another squeeze on borrowers, which results in further falls in consumer spending and in house prices.
Is a monetary crisis inevitable?
At this point, the government may try to bail the economy out yet again – or simply repay its debts - using more QE or other forms of money printing (steps 14 and 15). But if we do that then some kind of currency or monetary crisis seems inevitable, even if hyperinflation (step 16), may be an extreme view. The end result is step 17, a collapse in the government.
Now as I noted above, it may not pan out this way. But governments have a history of following the path of least resistance. And so far that's exactly what they've done. Britain's politicians talk about cutting the deficit, but will whoever wins the next election actually have the strength to push through the level of cuts the economy needs?
With all this on the not-so-distant horizon, it's little wonder that gold has resumed its uptrend. An ounce of gold now costs some €834. Closer to home, an ounce of gold costs £758, a new high against sterling. It has risen – or sterling has fallen – by some 10% in the last five trading days. As my colleague John Stepek noted yesterday, it's the best currency trade you can make.
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Dominic Frisby
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