U.K. Gilts Could Be World's Best Short

Judging by the break-even rates on inflation-protected bonds, the United Kingdom is home to the highest future inflation of any major nation. And that means shorting – or betting against – British gilts (government bonds) will probably rank as one of the smartest speculations over the next five years.

Long-term break-even rates for U.K. TIPS in 2035 show a 3.4% inflation rate – the highest in the G-10. This compares to 2.2% for U.S. break-even rates maturing in 2039.

The U.K.'s financial system is essentially bankrupt. In 2008, the aggregate cost of bailing-out its banks exceeded the entire value of England's gross domestic product. The government already owns most of the country's largest banks – including Royal Bank of Scotland (RBS) and Lloyd's (LYG).

But the big question for gilts is what happens once the Bank of England terminates or slows its QE program? Who will absorb the supply that was once consumed by BoE’s QE efforts?

The odds are pretty high that Britain will have a hard time finding buyers to finance its ballooning budget deficits.

That scenario, which is highly likely down the road once deflation is defeated, implies a major funding crisis coupled by sharply higher interest rates. The pound is also vulnerable and needs to remain at a low level in order to defeat deflation.

The above scenario, by the way, is also likely to play out in the United States eventually as well.

Comments

[chap08:]

Nice headline, but the evidence you present actually suggests that Treasuries would be a better short. If UK bonds have inflation of 3.4% priced in and we only have 2.2%, then I know which one I would least like to own. Both are toast, but if I'm going to have toast, I'd rather have it with some yield on top.

Oct 27 11:41 AM

[nobby73:]

Whilst I see most risks to the downside and a short Gilts position makes more sense than a long, I am not sure it's the best short out there. This comment provides one good reason.

blogs.telegraph.co.uk/.../

Oct 28 03:44 AM

[Clive Corcoran:]

While I agree with chap08's assessment, if things get nasty in the sovereign debt markets (which I suspect they will) it will become a Darwinian struggle and sterling denominated assets could be more vulnerable than even dollar denominated assets.
One other thought if Tony Blair does become president of the European Union (it just might happen) and if the gilt market starts to implode, then perhaps the UK may find its way to adopting the euro sooner rather than later rather than having to go to the IMF for an emergency loan.

Oct 28 08:02 AM

[BigBadBank:]

Er UK has already stopped QE (though we may start again soon) and nothing happened.

Oct 28 09:37 AM

[James Lewis:]

Clive comments are very interesting. If we were to join the Euro, then we would first need to bring interest rates in line with europes and peg our currency on 1pound-1 euro. Therefore this suggests slight weakening of the pound. So owning Gilts if you are an interntional investor may be a bad idea because of currency risk.

Of course the pound joining the euro is a very big step as we are essentially a monarchy. The pound with the queens head on it is the only real thing we have left from the days when we ruled the world through the British Empire. Of course with the Labour Government owning most of the banking system - we could join the Euro if things got really bad this side of the water. And Europe pushed forward. However I am not sure if this is the case, after all Spain and Italy are in such terrible state they may want to pull out of the Euro.

In terms of who will buy our debt. I urge readers to remember that that the FED was essentially an offshore UK banking network. The USA will (if they can) step up and buy our debt. But there will need to be some interest rate rises. But not the amount everyone is predicting. And maybe this will not strengthen sterling because of the state of the UK economy and the very obvious need to devalue the currency through QE.

As crazy as this may sound to everyone, my feeling is that the UK is in such deep trouble. That any attempts to restriant the QE program through concepts as 'rsponsible money supply control etc' will be very damaging. We need to print as much money as we can through QE as quickly as we can. We need to devalue our currency by 25% from where it is now. And we need to subsidise manufacturing so we can build a manufacturing industry on the back of weak sterling. We need to reduce un-employment benefits and have those that want to be unemployed working in low skill factories for a few days per week to get their money.

On top of this we need to inact vary favourable incentives for rich people to come to UK from other countries. Further to this we need to subsidise living costs by taking away greedy private companies making money on the back of running our country (utility companies etc) and by definition drive down wages.

This is a very tall order, I guess that not even 5% of the above will be done. Therefore expect a year of growth before the s*h*t really hits the fan. The UK is in a very bad place

Oct 29 10:06 AM

[Clive Corcoran:]

James

Your points are well stated. But if the UK has to sell gilts largely to foreigners they don't want an indefinitely long period of QE because as you intimate this will lead to currency devaluation.
As in many things this is all double edged - you cannot support a currency or gilt market by printing more of both.

Oct 30 02:45 PM