Hamish McRae: Britain has become a magnet for hot money seeking refuge
Economic Life: Why lock into a 10-year contract when you can sit on the cash and wait for better?
Thursday 07 June 2012
So what benefits are we getting from being a "safe haven" and how long might that status last? For those of us with long memories it is all a bit odd. Two post-war devaluations in 1949 and 1967, the IMF bailout of 1976, the ejection from the ERM in 1992, the surge in the deficit under the last government, and now higher inflation than the US, Europe or Japan – these are hardly the characteristics of a safe haven, in fact the reverse. And yet the Government is able to borrow more cheaply than at any time in our nation's history.
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Our status is of course a function of the fears about everywhere else: we may not look marvellous but at least we are safer than the other places. And we are not, to be clear, ranked quite as highly as Germany or the US: our 10-year gilts yield 1.6 per cent, vis-à-vis 1.2 per cent and 1.5 per cent.
Still, the top graph does make astounding reading: lower yields than at any stage since the Bank of England was founded. The Bank's first loan to the Government, by the way, was at an interest rate of 8 per cent. Typically UK government securities have over the past three centuries yielded somewhere between 3 per cent and 5 per cent. Anything below 2 per cent has been exceptional, just as the era of 10 per cent-plus in the great inflation of the 1970s was also exceptional.
They are also irrational, at least in the case of the UK and US. Why lock into a 10-year contract when you can sit on the cash and wait for the better opportunities that will surely materialise during the next decade?
They are also artificial. In the UK, yields would be somewhat higher, maybe much higher, if the Bank were not printing money to buy the stuff. It holds more than a quarter of our national debt. Yields in the US would be higher were the Federal Reserve not doing much the same, though the technical details are rather different.
And Germany? Here I think there is some reason for buying. Some at least of the buyers of German debt must be doing so in the hope that Germany will leave the eurozone or the zone will break up within the next decade, not a ridiculous expectation. In either of those cases they would be given bonds denominated in marks instead, which would then become much more valuable. So at worst you get your money back (and can sleep at night); and at best you make a sizable windfall gain on the currency.
Exceptional, irrational, artificial: so these yields cannot last and my own expectation is that we are close to the start of a 30-year bear market in bonds. But odd market conditions can persist for quite a long time and you can never get the timing right to call the turning point. My instinct is the turning point has been postponed by the odd events over the Channel, just as the turning point in global equity markets in the late 1990s was postponed by the dot.com mania. Just how this affects our markets is shown in the two bottom graphs.
The first shows the gap in the yield on Spanish bonds vis-à-vis the equivalent British ones. A year ago that gap was only about 1.5 percentage points, whereas now it is more than 5 points. The graph also shows the sterling/euro exchange rate. As you can see as fears about Spanish debt have risen, so sterling has risen against the euro. So people are getting out of Spanish (and other fringe European) debt, and getting out of euros.
The second graph shows sterling's trade-weighted index. As you may recall, we devalued by more than 20 per cent after the banking crash but now we have clawed back some of the way. Since the beginning of last year the pound has been stronger than the euro and the US dollar, with quite a sharp change against the euro continuing in the past week. Capital Economics, which prepared these charts, notes that sterling is now its highest since August 2009.
So we have safe-haven status. How long will it last? I suppose you could say it will continue as long as the turmoil in Europe persists. It is pointless to keep heaping criticism on the eurozone politicians and officials, for they are trying to cope with a situation none of them has experienced: managing economies in a fixed exchange rate system. The Bretton Woods system collapsed in 1972, and it was better designed than the eurozone because it did allow for periodic exchange rate adjustments.
Given the amount at stake, it seems likely to me they will continue to try to patch up the system for some time. Bretton Woods took several years to collapse. If that is right, and with one proviso, we retain safe-haven status for the life of the coalition, perhaps beyond. That proviso, of course, is that the deficit-reduction programme is broadly sustained.
So how might this benefit us? Well, it means we can finance the deficit at ever lower cost. Because the average maturity of our national debt is relatively long (which is good because it gives security against swings in market mood) we need several years of low yields to squeeze down the overall cost of funding the national debt. But at least our annual addition to that debt, running at more than £100bn, can be cheaply financed. Phew. It also cuts the borrowing cost for other borrowers at the margin, helping hold down mortgage rates.
However, the rise in sterling is a two-edged sword. On the one hand it will get inflation rates down by holding down import costs and energy prices. That will help boost demand. On the other, it will erode our cost advantage as an exporter. At the moment that is not a problem – exports to the non-eurozone world are higher than before the crash – but an over-strong pound is as much a problem as an over-weak one. But far better to be a safe haven in uncertain times than to be at the mercy of every attack by the speculators, as we were when we were kicked out of the ERM.
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