The implications of 100 year Gilts are shown by the untwisting of “Operation Twist” and inflation prospects

There has been an interesting juxtaposition of stock markets overnight which has gone in the opposite direction to the old economic world/new economic world debate. Yesterday evening the US Dow Jones Industrial Average rose by 217 points or 1.7% to 13,177 whereas this morning the Shanghai All Ordinaries Index has fallen by 64 points or 2.6% to 2391. For twenty-four hour period that is quite a shift and we see an economy that is still growing strongly being outperformed by one where the performance looks to have improved but the jury is still out. The problem with using stock markets as a guide is the question this poses or which price is right? Yesterday’s or today’s (or neither)? In other words the television programme “The Price is Right” missed out not always in the title.

The US Central Bank or FOMC Meeting

There was little real news here as the FOMC confirmed that it thought that the US economy had improved since its last meeting. For example its statement that the US economy was “expanding moderately” dropped this bit “notwithstanding some slowing in global growth”. We also got these.

Labor market conditions have improved further……. Household spending and business fixed investment have continued to advance……the unemployment rate will decline gradually toward levels that the Committee judges to be consistent with its dual mandate.

Nothing especially ground shaking is there? There was something further down the report however which could have been written by the Bank of England.

The recent increase in oil and gasoline prices will push up inflation temporarily, but the Committee anticipates that subsequently inflation will run at or below the rate that it judges most consistent with its dual mandate.

So an admittal of inflationary pressure and confirmation that the central bank mantra where inflation is always tempoary still applies. For newer readers my financial lexicon defines “temporary” for central bankers and politicians as any period between now and the end of time!

Operation Twist “Untwisted”

Last September the FOMC announced the above mentioned programme to reduce longer-term interest rates. It has spent a considerable sum of money on this but they are now higher than when it started. I established some benchmarks at the time.

In terms of government bond yields then the five-year yields 0.84% the ten-year yields 1.94% and the thirty-year yields some 3.21%. Moving onto currencies then the trade-weighted US dollar index stands at 77.15.

The two main tests are the ten-year yield which has now risen to 2.18% and the thirty-year yield which has risen to 3.33%. So as we stand that is a fail for Operation Twist and the implied aim of reducing the value of the US Dollar is not going well either as the trade weighted dollar index has risen to 80.37. The economic effect of this was supposed to be a boost for the housing market which has remained mostly in the doldrums.

Another implication of this feeds into a more recent theme the weakening of the Japanese Yen which has now fallen to 83.40 versus the US dollar. No wonder the Nikkei 225 equity index has broken the 10,000 barrier.

Comment

There is plenty of food for thought here for those who support more widespread central bank action. A problem I have labelled under “exit strategies” will now be arising for the FOMC. The bonds it has bought under Operation Twist are making a loss on a mark to market basis and any further economic strengthening will lead to higher yields and more losses. We have become used to very low levels of bond yields in some countries but in a recovery we are likely to see considerable rises. Adding to this the objective of Operation Twist was to buy longer -term bonds so the problem will remain for a long time. It is not only the European Central Bank which has issues with its balance sheet.

For me this is one of the problems of Quantitative Easing type policies which is that for what have been limited and debatable gains (even supporters have taken to using the owrd counterfactual which is applicable to anything…) balance sheet losses are potentially wrapped around  the can which is kicked into the future. In the UK the Bank of England purchased some £691 million of out 2060 maturity bond yesterday and in spite of this the price fell heavily (1.8 points).

The UK considers issuing a 100 year Gilt (government bond)

This idea was first floated before Christmas and has gained ground overnight. As ever the mainstream media has handled it badly with phrases like “debt for generations”. As it does not change the amount of debt we have or the time period we intend to have it for this is utter rubbish as we would have been borrowing in one form or another anyway.

The actual position requires a little more nuance. For the UK taxpayer it is an excellent idea as it locks in low borrowing costs. As someone who has worked through periods where we have had to pay 15% on our longer-dated debt then current 3% and a bit seems very low and for the issuer that is good. Also it helps to avoid crunches in difficult economic times where debt needs rolling over and we have seen this affect Greece this month with the deadline for her March 20th bond approaching with little cash to pay it without another bailout. Debt management is a UK strength and this would improve it.

The other side of the coin is buyers and here is the problem, who would buy it? To buy at such levels for such a long time you either have a very pessimistic view of the UK economic outlook probably combined with a very optimistic outlook on UK inflation, or you do not know what you are doing! Oh and the problem with an economic view that pessimistic is will there be any money to pay you in 100 years time? The current economic outlook which I discussed only on Monday looks rather stagflationary and that is a long way from the best outlook for a fixed coupon bond holder.

Will the Bank of England buy it?

Under its current strategy of buying longer dated gilts such as our 2060 stock the answer is yes I think. There are thresholds to cover off such as it will not buy for a week after issue and it only buys Gilts with more than £4 billion in issue. If you want the day it will probably be Tuesdays as it tends to buy the longest dated stock then. Mind you perhaps we should be looking at the Bank of England’s balance sheet too as UK Gilt yields are following American ones upwards with our ten-year yield now at 2.27%. Losses on a 2112 maturity bond will take a lot of hiding for a very long time, does Mervyn King have a son or daughter ready to step into the fold? Oh and do they have any kids as well?

A Musical link

As purchasers of such a Gilt (including possibly UK taxpayers and their children and granchildren should the Bank of England buy it…) are likely to have as troubled a time as those who have held our previous long-term Gilts like War Loan I thought they might like something to sing. From the Welsh songstress Duffy.

I don’t know what you do
but you do it well
I’m under your spell.

You got me beggin’ you for Mercy (yeah yeah yeah)
Why won’t you release me (yeah yeah yeah)
You got me beggin’ you for mercy (yeah yeah yeah)
Why won’t you release me (yeah yeah yeah)
I said release me (yeah yeah yeah)

Oh and as a final thought for you if the government had any faith in its inflation forecasts should we not also have a one hundred year index-linked Gilt?

 

 

This entry was posted in General Economics, Gilts, Quantitative Easing and Extraordinary Monetary Measures, Stagflation, UK Inflation Prospects and Issues. Bookmark the permalink.
Subscribe Find an Adviser
  • James

    As you say, Shaun, the media and the Labour party have both talked about this as saddling us with debts for generations, which neatly encapsulates the extraordinary paucity of rational debate in the press and politics.
    I am beginning to think that it really won’t matter f the press has resticted freedom, as it doesn’t seem to do much real journalism.
    Off topic, but I hope that you saw the fantastic picture of Juncker apparently throttling the Spanish finance minister in the finance section of the Telegraph. A picture speaks a thousand words.

  • Ian_jones

    100 year debt, so your great great grandchildren are paying for you to overspend now. You know the run on gilts is coming to an end when they bring out something like this. No doubt pension schemes will buy it only to find massive inflation erodes it thus ensuring pensions are nationalised in the future.

  • Robert S

    Shaun,

    Please forgive this amateur question, but it’s something that I’ve never understood.  Which interest rate does any government pays on its bonds?  For example, you say that “…it locks in low borrowing costs.”, which I believe to mean that if they issue the 100 year bond at, say, 3%, then the Government will pay 3% for 100 years.  However, we then move to Greece where we’ve seen the interest rate shoot up.  So is Greece now paying the higher interest rate, or the rate at which the bonds where issued?  Do governments pay the fixed interest or what ever the interest rate is being paid for in the markets?

    Thanks very much.

    Robert

  • http://tubeshaker.com/budget-2012-will-100-year-bonds-work/ Budget 2012: will 100-year bonds work? | TubeShaker

    [...] needs to find buyers with a sufficiently gloomy outlook. Are there enough Eeyores out there? He writes: To buy at such levels for such a long time you either have a very pessimistic view of the UK [...]

  • Anonymous

    Hi Shaun, great few posts. I no longer trouble myself with the counterfactual because reality is overtaking events….I was interested in Draghi’s recent speech where he said ” Indeed, we can observe that most countries with strong current account
    deficits prior to the crisis had also experienced substantial increases
    in prices.”

    A policy to depreciate sterling hasnt helped, it would seem. Is it not the case that the UK has major productivity problems which have been exposed by the very policies which were designed to help.

  • JW

    Hi Shaun
    Why not go for broke? Devalue the currency and debt in one go. Issue £bns of 1000yr gilts to replace all existing bonds plus a bit. BoE buys the lot. Wont go bust because it can always print money, but devalues currency by whatever the ‘mark to market’ is for the yield. As we seem to be doing this anyway , slowly and dishonestly, why not just get it over with?
    As I typed this, I began to think that the clear illogicality of doing this was not so clear, oh dear, are we in the ‘looking glass’ world?

  • http://twitter.com/thebibbler The Bibbler

    Surely this is the BOE’s exit strategy for QE – buy these long dated gilts and hope that that aliens invade in the next one hundred years.  

    I haven’t seen any other plan from them ….. 

  • The_forbin_project

    who knows the future?  1912  the Great War had not happened and we had an Empire
    100 years later ………  we’re broke!  another 100 years? might be rich again

    and any economy based on burning fossil fuels with be a distant memory ….
    peak oil production will be well and truly in the past   and the Great Unwinding of Debt would have taken place  thus the greatest deflationary period ever know – with maybe one or two wars  taken place

    or in a 100 years time –

    “whats this ? “ 

    “oh thats one of those bond thingys the latter day British Gov issued before the Great Depression war  ”

    ” they really believed they would get there money back then ? ”

    ” guess so , they believed in sorts of silly things then – there was this religion called ‘chicago’ economics  , based not on 3 laws of Themodynamics  but some dead guy’s hand controlling everything ”

    ” thats just daft , you made that up! ”

    “no , really, they were quite delusional then…..”

    or when these bond expire the world really could be dystopian!!

  • Rods

    Hi Shaun,

    Another excellent blog.

    You only have to look at the history of WWI war bonds, to see that the most likely outcome is too lose money buying these.

    Slightly off topic: What do you think of the latest mis-selling scandal, where UK banks have been selling complex financial instruments as part of making loans to SMEs.

    The banks seem to think it is perfectly reasonable for the average fish and chip shop owner to understand all of the implications as he signs on the dotted line.

  • Andy Zarse

    The new 100 yr bond is ideal for securing the annuities of new born babies looking to take early retirement….

  • Anonymous

    Hi Robert

    There is an element of the exception proving the rule about this answer but the UK situation is as follows.
    Around 80% of the debt we issue is what are called conventional Gilts and the price and interest rate is fixed at the beginning. Usually it is close to the coupon but there is some last minute manoeuvering by issuing at say 99.50 rather than 100 to make the yield attractive enough.

    The other 20% in the UK is index-linked debt so that the variable amount for us is not interest rates but is in fact Retail Price Inflation.This has proved expensive in the last couple of years as inflation has overshot its target and has been an offsetting element to us being able to issue conventional gilts cheaply.

    So apart from inflation the cost of a bond yield rise for the UK is when we replace maturing debt or we issue new paper to cover our budget deficit.

    For many other countries this is true but some have elements of variable debt where it responds to market rates (Italy comes to mind as having some of this). This is rarely daily but is more likely to be 6 monthly adjustments or quarterly.

    So in a sweeping generalisation the cost of rising bond yields is in the main when you issue new paper..

  • Anonymous

    Hi Shire

    Thank you. The 2007/08 £ depreciation (20-25%) has been a disappointment for those who felt it would improve out trade balance substantially and of those the Bank of England plugged this line hard. Ironically the Bank of England forget its old rule of thumb of a falling £ on UK inflation and monetary conditions (or did it?).

    Your productivity point is interesting I have some thoughts in this area as to how economic theory has gone wrong re: £ depreciations and will write a post on it. I think we do better than we think but worse than conventional theory argues..

  • Anonymous

    Hi JW

    I was about to reply saying that the March Hare would issue 1000 year Gilts but then I thought wrong way around Shaun! The March Hare would be silly enough to buy them……

  • Anonymous

    Hi the Bibbler and welcome to my part of the blogosphere

    When we get paranoid about Alien invasions I often wonder if hyper-intelligent Aliens might not have better things to do than meddling with us!

  • Anonymous

    Hi Forbin

    You make a good point. What will life be in 100 years time? I did the eulogy at my Grandmothers funeral a few years ago and pointed out that over her life (nearly 100 years) she had probably seen as much change as a human would………

    Was I right? Actually I am very unlikely to ever know!

  • Anonymous

    Hi Rods

    Again and again we learn that banking is in an equivalent state to “There is something rotten in the state of Denmark” but rather than a full reform we patch repair and let them go back to the same behaviour..

    That’s what bothers me most, we have not fixed it and I expect other scandals to emerge.