Graph-heavy post coming up! But to assuage the fears of the faint-hearted, it aims at the question of whether the market is still keen to buy the debt of the UK Government.  Oh, now you’re rivetted.

For both of you still reading, for a dull reason I was looking at the forward yields on gilts.(no don’t switch off).   And I noticed this:

This graph means that the market expects spot rates to be around 5.5% in 9 years’ time, before declining down to 4% in 25 year’s time.   This struck me as strange: whereas the rise from <1% is understandable, how can the financial market have such a strong view about what will happen under the successor to the successor of Cameron**?

Of course, this is naive.  Financial markets may offer no free lunches, but this does not mean that their predictions are perfect.  Not being able to make money out of them is not the same thing. What is happening is that demand for longer duration bonds is exceeding the supply. One factor must be QE, which the chart below of the gilts bought by the ‘Asset Purchase Facility’ shows has put a fair amount of £ into that end:

But the fact that the (red) curve was downward sloping before the onset of QE suggests this is not ALL about the Bank’s purchases.   A little may be about it, because the fall off is now steeper.  And this ‘little’ is important: it may mean the Bank overpaying by 5-7% for #80bn or so of gilts – a lot of money.  (However, the market has been buying about as much from the government at similar prices). However,  if you were not forced subsidize the entire financial system, you ought to be wary of paying such prices/receiving such low yields.  But if this is so blindingly obvious, why are there no speculators driving them down in value? Is this ‘money left on the table’?

I think the answer is No: even if you think a price is ‘wrong’ i.e. a wrong prediction of the future, you don’t deal it if you think there is a player in the market likely to keep it wrong for many months. I remember when the prices of many stocks were Wrong, but timing their downfall is very different.

The other jarring observation about the gilts market is what outstandingly bad value longer dated index linked gilts are. As described on Bond Vigilantes, they are both expensive and risky, owing to their extreme sensitivity to changes in yield. Look at the yields on a graph (they are not forwards, but rather what real return you are promised for holding IL gilts out to the period shown on the X axis).   They suggest you can lock up money for 15 years, and get paid the RPI inflation rate plus 1%.

Now, you can see from an earlier date chosen at random that this is not a particularly new phenomenon.  It is not, for example, something that has come as a result of QE making melodramatists think Hyperinfation is Round the Corner.  Nor, obviously, can it be about default risk, which affects Index Linked gilts like ordinary ones. So, if it is not about inflation risk, it must represent another kink in the market.  There seems to have long been a surfeit of demand over supply for index linked debt.  Why?  Because they match liabilities so well: pension funds need something looking exactly like this.  Which is why, as I argued before, it would be sound government policy to issue more of them.

But I still think they are lousy value, and as someone not investing for a pension, I am steering clear: many’real economy’ investments yield a return that is linked to the inflation in the economy, more or less – and can hopefully promise a real return of more than just 0.50%.  (this takes some skill, however: buying equities before a burst of unexpected inflation would hurt some).

A consequence of this low real yield is that the implied inflation rate from the market is probably too high.  This is gotten by taking the forward real graph (not shown) from the nominal graph.  The Bank does it for you.

This may be important: if key decision makers (The Bank of England; Guido Fawkes; the Daily Mail) should look at this graph and think ‘the markets are expecting high inflation’ then it may cause rates to be higher than they would otherwise need to be.

What do I conclude from this mishmash of observations?  One: these ‘kinks’ in the market seem to stem to some degree from a still-large demand for government bonds and a massive amount for index-linked.  Some may remain after QE ends; retiring pensioners need steady sterling incomes.   Although the end of QE may bring prices down, this has been anticipated since September, since when the 25 year gilt yield has risen by just 30bps.  There don’t seem to be many people speculating on the sharp fall in longer rates that would supposedly follow the end of the programme.  Of course, this may mean that when QE ends, the price action is disorderly.  But remember that the MPC can tighten in may ways: raising rates while keeping QE in place, for example.

Two: by driving their prices so high, the two forces of pension funds covering their liabilities, and a big QE programme are making investing in such bonds very unattractive to genuinely speculative capital.  This ought eventually to force such money into the ‘real’ economy.  But ‘eventually’ is too late for people joining the dole.   And speculative capital can just speculate; it can drive up equities, play with commodities, all sorts of things.

Three: the government should definitely issue more index linked debt, full stop.  It has an excellent means of covering its inflation risk: its tax revenues move with inflation.  By doing so, it foregoes the opportunity to mug the gilt market  – but that is not a great opportunity, rather than a one-off reward followed by a decade of pain.

Does anyone agree or disagree?  I am quite new to speculations of this kind

*or is that conundra?  Boris, if you’re reading, add to your 100 achievements, that include unveiling statues, visiting the Queen Vic, and bringing down knife crime, and give us the plural.

**In a ruthless coup, Boris takes over after 2 years. Then, after what the Conservatives recall  with a shudder as ‘that incident’, Tim Montgomerie ascends to power in 2019, with Louise Bagshawe taking over his the vital second in command role of TwitterMaster.

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6 thoughts on “Gilt market conundrums*

  1. I think Ed Cannon at Bristol has written about this as a long standing phenomenon as part of his PhD. He was supervised by John Muellbauer. Google both and see.

    I don’t think the Bank could credibily raise % without ending QE. That would confuse the markets. The Bank is only supposed to use % – it got to use QE because it had run out of % options.

  2. No, that is not the case. Gua has discussed this with regard to the Fed
    http://blogs.ft.com/money-supply/2009/12/15/fed-exit-strategy-five-questions-some-tentative-answers/
    http://www.ft.com/cms/s/0/1d4790e8-e9bc-11de-9f1f-00144feab49a.html

    It depends on what part of the curve they want to affect. It is quite conceivable that they may want higher short term rates while keeping the longer term rates in place as they are.

    Paul Fisher of the BOE also acknowledges this
    http://www.bankofengland.co.uk/publications/speeches/2009/speech413.pdf

    see 41.

    On the way down there was one route, but two on the way up.

    Thanks for the Cannon reference. It is certainlylongstanding – I think something the government could have done something about earlier.

  3. I’ll take you up on that bet. Tipple of your choice on the outcome – £10bn QE reversed or rates above 1%.

    You see, I wonder whether the first pressure to come to bear will be savers whinging about rates on their accounts, while inflation hits 3.5% in 4-5 months time . ..

    best, G

  4. Giles

    I’m not going to even try and pretend to understand most of this post, but if I get some of it right you it would be valid to quote you, out of context of the rest of the post, as saying: “these ‘kinks’ in the market seem to stem to some degree from a still-large demand for government bonds and a massive amount for index-linked.”

    One question then. How would you explain that against the decision by PIMCO to cut holdings of UK (and US0 treasuries? See http://www.bloomberg.co.uk/apps/news?pid=20602007&sid=anPTcp0yNqpw I note the decision by PIMCO also to go ‘underweight’ on inflation protected securities (in the US).

  5. I think PIMCO are being rational: UK bonds do not offer that great a return. But they act with more choice than many of the pension funds investing.

    Also, it is worth not going overboard: at 4%, gilts may be bad value. At 5%, they may be great value. 5% is not “bankruptcy here we come”. Banktrupcy would be not being able to borrow at anything except ruinous, debt-spiral terms: Healey was threatened by this in the 1970s, despite debt being much lower, because no-one trusted them not to inflate the debts away.

    Unsurprisingly, in my view: the people in power had a large and influential fringe who no doubt agreed with Dave about the honourableness of debt repudiation!

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