GILTS IN LINE FOR WORST FIXED INCOME INVESTMENT / THE FINANCIAL TIMES COMMENTARY & ANALYSIS ( VERY HIGHLY RECOMMENDED READING )

Gilts in line for worst fixed income investment

By James Grant

Published: January 24 2011 12:03


Early competition for “worst fixed income investment of 2011” is stiff. There’s much to be said for – or, rather, against – the obligations of the state of Illinois, the debts of the peripheral nations of the eurozone and the trillions of yen-denominated Japanese government bonds.


Better, however – or, rather, worse – is a dark horse. Gilts yield no more than the running rate of UK inflation. And they are denominated in an inflation-prone currency that has lost more than 99 per cent of its original gold value. With respect to the solemn obligations of Her Majesty’s Treasury, the balance of risk and reward favours the short seller.


The underlying problem is that “gilts” are ungilded. And given that the modern currency is virtually weightless, “pound” too is a misnomer. Not since 1931 has sterling (another misnomer) been exchangeable for gold at a fixed and statutory rate. Not since 1971 has any currency been even remotely tied to a fixed standard of value. In place of the gold standard, the world has put in place a macroeconomic forecasting and price index standard. In monetary governance, we have swapped the price mechanism for mandarin rule.


If you haven’t heard the creditors complain, it’s because they have had it their own way for so long. Since the inflationary nadir in the mid-1970s, 10-year gilts have rallied to 3.7 per cent or so from 15 per cent. Richard Sylla and the late Sidney Homer, in their standard volume A History of Interest Rates, show that bond yields have risen and fallen in generation-length intervals since the late 19th century. The past 30 years or so have composed the falling portion of the cycle.


Whom should investors thank for this pleasant, persistent tailwind? The mandarins have modestly raised their hands. “Since the monetary policy committee was set up,” Mervyn King, governor of the Bank of England, declared in 2007, “economic growth has averaged 2.8 per cent a year – a little above the postwar average rate – and there has not been a single quarter of negative growth. The average deviation of inflation from target has been just minus 0.08 percentage points.”


The monetary policy committee is, of course, the Bank’s interest-rate setting arm. It came into the world in 1997 when Gordon Brown, as chancellor, cut the Bank loose from Treasury control. With this stroke, he seemed to realise the hopes of the 20th century’s great economic rationalists, from Irving Fisher (author of seminal works on price indices as well as that ill-starred 1929 stock market call) to John Maynard Keynes. The Fishers and the Keyneses wanted to separate monetary value from the vagaries of mining. They wanted to separate domestic interest-rate policy from the ball and chain of exchange-rate policy. The wit of man was more than equal to the job of contriving a monetary system based on cold analysis.


In fact, the wit of man has shown rather poorly – and not only in the past five fiscal quarters, during which the Bank missed its inflation target by a wide and widening margin. A one-paragraph history of modern monetary systems would take something like this form. The classical gold standard delivered point-to-point price stability, along with interim booms and busts and panics, in the 100 years to 1914. Its successor – a dog’s breakfast of monetary makeshifts, from the so-called gold exchange standard to the present-day mandarin method – has delivered chronic inflation, along with interim booms, busts and panics in the 97 years since.


Ultra-low interest rates were suitable enough during the classical gold standard, when the price level tended to fall in peacetime and rise in wartime. They are demonstrably unsuitable – certainly, for bondholders – under a paper-currency system. No longer are prices allowed to fall, even when the cost of production is falling. Rather, the Bank of England – along with most every other central bank under the sun – actually strives for debasement. In the UK, in December, the rate of inflation measured not 2 per cent, the Bank’s bullseye, but 3.7 per cent.


What should a gilt owner do? Sit tight, comes counsel from on high. The inflationary bump will pass, the central bankers insist. Mark it down to one-offs – in value added tax, in commodity prices – or the previous weakness in sterling. Notice, please, the apologists urge, the UK’s measured growth in wages and its abundant spare productive capacity. Observe, too, the lack of concern, let alone panic, in the market for inflation-linked bonds. In other words, trust the mandarins – this time – not to let a little inflation become too much.


Because the future is a closed book, the apologists may be right. However, on form, they are wrong. In 1931, a pound bought almost a quarter ounce of gold. Today, it will buy one-850th of an ounce. The 21st-century model gilt is almost designed to depreciate. This year – in the world’s worst bond competition – it may just take first place.


James Grant is the editor of Grant’s Interest Rate Observer


Copyright The Financial Times Limited 2011