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A Stable Rock During Stormy Times

Many of you have of course been aware of the crisis in the UK government bond market following ex Chancellor Kwasi Kwarteng’s recent mini budget in which more tax cuts and government spending were promised. Many will say that Kwarteng’s mini budget was the reason behind the crisis as the price of Gilts crashed and yields spiked massively. My argument will be that this crisis had been brewing for decades and that the mini budget was the straw that broke the camel’s back.

Let us look at what it means when Gilt prices crash and yields rise. There are a few reasons why this might happen. The first one is a rise in inflation like we have seen recently to around 10%. For most of 2021 the 10-year Gilt yield was below 1% while inflation as measured by the CPI ran at 5.4%. So why would any sane investor accept a 1% interest payment from HM Treasury when the currency is being debased at a rate of 5.4%? Probably because investors thought the Bank of England and the government would sort their affairs and control inflation and fiscal spending. The other reason investors might want to sell Gilts in the secondary market is if they are for foreigners whose currencies are rapidly appreciating versus the British pound.

So why have things suddenly gone from a relatively stable Gilt market at the end of 2021 to total chaos in 2022? I would say that the underlying reasons are the inflation situation and the fiscal profligacy of the UK government ever since the 2008 crisis. Sure the breakout of the war in Ukraine in February this year helped push energy prices higher but they were already rising prior to 2022 and as we saw above inflation was already pushing above 5%. The Bank of England held off raising interest rates from almost zero ( stayed below 1% since 2009) up until the end of the year despite about half a trillion pounds of QE during the pandemic and all the government spending during the same period.

The Bank of England continued to raise rates this year but not near enough to keep pace with double digit price rises. Their excuse was that inflation was being pushed up by Putin and his war on Ukraine so the Gilt market was not too concerned but the 10-year Gilt yield went from around 1% in the beginning of the year to around 2.75% by June. Investors still seemed to be giving the Bank of England the benefit of doubt despite CPI escalating to 12.7% annual rate in June! Don’t forget even with CPI running at 9.9% in August the Bank of England base rate was still below 2% at 1.75% so foreign investors also started selling the currency and that is why the rout in Gilts in late September corresponded to an all-time low for the pound of around $1.03 late on Sunday night of September 25th. The mini budget on the 23rd and the £150 billion energy package announced a couple of weeks before did not help investors’ confidence in the currency nor Gilts either.

Aside from almost bringing dow the final-salary or defined benefit pension system in the UK the volatility in the bond market and rising rates in 2022 has led to the worst performance for the 60/40 stocks and bonds portfolio in 100 years according to Bank of America. Gold, especially for UK residents, has performed very well in a world in which the S & P 500 and Nasdaq index are down 25% and 34% respectively YTD. As of the close of trade on October 14 gold in sterling was up about 10% YTD while on the day sterling hit $1.03 it was up about 17.4% YTD. Even in dollar terms gold is down around 10% YTD which is a much better performance than stocks and government bonds (TLT I shares 20-year Treasury bond ETF is down 31.7% YTD).

Even the FT has been giving the “barbarous relic” as Keynes called the gold standard so credit as it reported recently that the Royal Mint is minting it! (2) The Royal Mint recorded record profits in the last year as people realise that having some of the shiny yellow rock might just help them navigate the current financial and monetary stormy waters that we face.