Tuesday, Oct 27, 2009

Not like Japan

FT: Why sovereign bond yields will explode

Serious article which argues that prolonged deflation is unlikely and the end of QE will bring about a bond and equity collapse.
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Posted by letthemfall @ 12:03 PM (1391 views)
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1. chrisa said...

'Serious article which argues that prolonged deflation is unlikely and the end of QE will bring about a bond and equity collapse'

Another reason why IT WONT END.

Tuesday, October 27, 2009 12:25PM Report Comment

2. drewster said...

Excellent article.

I'm inclined to agree with chrisa. The end of QE would spell disaster for asset prices; therefore they won't stop QE.

Now, what effect will never-ending QE have? One day they will have printed so much that inflation will have eaten away at the debt monster, and the problems will go away. In the meantime we can expect continuous higher-than-normal inflation, random guess between 5% and 15% per annum. Once people realise that this is the plan, they will pull their savings out of pounds (or dollars / euros / other QEing currencies) and will invest in decent-yield Australian dollars. The currency will collapse, Iceland-style.

Two options: QE either devalues our currency slowly and gently, or devalues our currency quickly, suddenly, and without warning (like Iceland).

Tuesday, October 27, 2009 03:57PM Report Comment

3. inbreda said...

bonds are not the friends of inflation. QE will cause inflation. A potential bond collapse is surely the thing that will force rates up?

Tuesday, October 27, 2009 06:09PM Report Comment

4. crunchy said...

Where is stillthinking? I would like to hear his views on this.

Tuesday, October 27, 2009 06:46PM Report Comment

5. stillthinking said...

If I must nonchalantly mutter a few words on the subject,

I think that nominal yields in sterling are irrelevant because it only makes sense to consider changing exchange rates in conjunction with the yield i.e. a european holding euros who bought in 2007 has lost about 30% so far. Yields in percent and exchange rate strength in percent (or lack of it) are interchangeable in terms of real gains. So relatively speaking from a european view, if you were to take the view that sterling falls against the euro at 10%(whatever) a year, then if the gilt were priced to attract euro buyers instead, the yield would change to around 10% and the price would have accordingly fallen to allow equitable exchange ( the euro buyer can buy and then sell without losing or gaining).

But this didn't happen so I think that gilts are purely domestically driven at the moment, pension funds are legally obliged to buy gilts (so they aren't price setters) and they aren't seller either because the law about withdrawing entitlement from your fund before 55 is suddenly cancelled, and the retirement age is going up, and house/car/debt insurers are obliged to hold a steady amount. Also recently I read that the banks are obliged to hold gilts i.e. your on demand account (NOT your savings locked up account) is going into gilts.

So, I think the price and yield are currently dictated by legal mandate, and the if you like "non-mandated" price and yield will show up in the exchange rate instead. Thus to argue for an explosion in gilt yields is equivalent to argue for a sterling collapse.

Tuesday, October 27, 2009 08:31PM Report Comment

6. crunchy said...

Thanks for that stillthinking, an impressive case as usual.

Tuesday, October 27, 2009 09:15PM Report Comment

7. Van Hoogstraten said...

Unfortunately for the indebted, there is no inflation related get out of jail free card this time.

Various governments around the world produce phoney CPI statistics which limit wage rises and in countries which allow unfettered immigration, such as the UK, the possibility of its labour force to leverage a pay increase enough just to keep pace with the real rate of inflation is non existent.

People are just going to get poorer.

Tuesday, October 27, 2009 10:32PM Report Comment

8. fallingbuzzard said...

For how long can gilt purchases be funded domestically, assuming that their obligations are not changed? Can we even be Japan?

Tuesday, October 27, 2009 11:03PM Report Comment

9. drewster said...


"But this didn't happen so I think that gilts are purely domestically driven at the moment, pension funds are legally obliged to buy gilts..."

Gilt yields are currently quite low. Normally this would imply that investors (both domestic and foreign) have confidence in our currency and confidence that inflation will be kept under control. However these are not normal times - instead what is happening is that the BoE is printing fresh banknotes and using them to buy gilts. This quantitative easing is keeping gilt yields low. It's an artificial government-supported smoke-and-mirrors trick. By keeping gilt yields low, investors who want a decent return on their cash are forced to lend to business or invest in shares. This is why share prices have risen and why yields on corporate bonds are so low, despite the dismal economy.

In any case, gilts cannot be purely domestically driven. Foreign buyers make up a significant chunk of buyers; domestic pension funds have actually been backing out (see e.g. Telegraph: In fact, the increased supply of gilts so far has been soaked up foreign buyers, mainly central banks).

There are two possible outcomes:

1) A slow, steady devaluation of the pound, as never-ending QE causes relatively high inflation and investors slowly decide that the pound isn't a worthwhile investment. Eventually the debt is inflated away, the economy recovers, albeit with the pound at a lower level. Unemployment remains low even as prices rise.

2) A sharp shock, all foreigners lose confidence in the pound and sell en-masse. Government forced to slash spending and hike interest rates, just like Iceland. Unemployment is high and prices rise too, causing general unpleasantness.

Unlike Iceland, all our debt is denominated in Sterling. (Those foolish Icelanders borrowed in Euros and other foreign currencies). This means outcome 1 is still open to us. Outcome 2 however remains a distinct possibility.

Wednesday, October 28, 2009 12:24AM Report Comment

10. drewster said...

Incidentally, Ambrosia Devon-Custard thinks Iceland's devalued currency is a good thing for the country:
Telegraph: McDonalds flight shows Iceland's Policy Works.

While a devalued pound would be good for jobs and for exporters, it would be a pain for higher petrol prices, higher food prices, and more expensive foreign holidays.

Wednesday, October 28, 2009 12:38AM Report Comment

11. crunchy said...

9. drewster said..."While a devalued pound would be good for jobs and for exporters, it would be a pain for higher petrol prices, higher food prices, and more expensive foreign holidays."

As Sir Freddie Laker would say, "Book early!"

Wednesday, October 28, 2009 01:47AM Report Comment

12. stillthinking said...

I am not so sure that foreign buyers are still so keen, as I understand it, the BoE is now the majority holder across many spans of maturity dates. Also I can remember reading about some fund manager complaining because it was a lottery which maturities the BoE would buy, which sounds suspiciously like holding yields down through uncertainty rather than price fixing, i.e. their ability to control the price is beginning to slip.

Anyway, holding yields down requires sterling to fall is what I mainly think, so what sets a floor for sterling? Presumably when sterling is so weak that UK assets/production become fair value, which would show up as foreign asset purchases, which you already see in central london property purchases. Given we are coming to that point if not there, then the devaluation of sterling is nearly complete, which is why Darling is such a fake sh*t, because he implies he has timed the rescue of the economy when all that really has happened is that the planned target devaluation has been achieved, with all the negative effects on people who foolishly trusted the UK pound as a reliable store of wealth.

But I don't think devaluation works as an economic fillip because although you can alter the import/export balance you can only do so by destructively reducing overall activity (bankrupting some of the foreign export firms and killing their demand). But who knows what is going to happen, 2010 will be the big year, suppose the government can't tighten due to strike action etc etc, suppose the resurgence in our "exports" runs up against a lack of skills, or even a shortage of workers at those prices due to benefits(benefits covering unaffordable housing). There are still many reasons the UK looks like an unlipsticked pig. I think that creating several generations under the age of forty without a property link to the UK will end up in emigration as people consider their position, the debts of the country, the quality of services.

I have a suspicion that this is what Thatcher meant with her right to buy, the UK was is such a dire situation, brain drain was coined then, that she needed some method to stop people leaving, but there is nothing holding the under 40s here today or even tomorrow. We will see.

Wednesday, October 28, 2009 10:53AM Report Comment

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