Gold, Recession, and Why Britain's Winning the Currency War
Depending on how you look at it, the Bank of England's doing its job brilliantly...
Preliminary data released this week show that Britain has fallen back into recession. UK GDP shrank for the second consecutive quarter in the first three months of the year, meaning Britain's first "double-dip" recession since that 1970s.
In truth, this was not unexpected. Nor was this week's other news that UK government debt continued to rise in the year to March, hitting 66% of GDP according to the Office for National Statistics.
Nonetheless, with debt growing and the country seemingly as far away from a meaningful recovery as ever, it seems an appropriate time to consider the likely environment British investors will face over the next few years - and what it all might mean for anyone who has made a gold investment.
We have noted before that there are five ways a government can deal with its debt:
Economic growth - The only meaningful claim a sovereign has on being able to repay is its power to tax. This claim becomes wobbly when the economy from which tax revenues are generated stagnates;
Raise taxes - Aside from this being counter-productive, slow or negative growth makes raising taxes very difficult politically;
Borrow more - Repay and service existing debts by taking on more debt. In practice, there tends to be a limit to how much investors are willing to lend countries. And, as we'll see in a moment, that limit can be hit suddenly and with little warning;
Inflate - Repay, but in money that's worth less than when you borrowed it. Generally this option only applies to debts denominated in domestic currency and where a country has control of its own monetary policy;
Default - Just don't pay.
Traditionally, a government like Britain's has managed its debt through a combination of the first four measures. Bondholders would prefer the government to use only the first two. The third is less-than-ideal since it can lower the value of bonds already in circulation. The fourth and fifth clearly impose real terms cost son lenders.
When an economy hits bad times - as Britain's has - the balance shifts and borrowing and inflation do more of the work, simply because the first two measures are not feasible. This is the environment British investors can expect in the years ahead. It's the one we have now, in fact, just dragging on and getting incrementally more intense.
But what's the endgame? Where and how will this crisis end?
The short answer is it will most likely end the way all such crises end: with the creditors paying the bill.
How exactly will this happen? To be blunt, we don't know. No one does. But we can hazard a guess.
Policymakers will try to steer a nervy course between two rather unpleasant possibilities: a debt crisis, such as that engulfing Europe right now, and out-of-control inflation.
Here's a closer look at how those scenarios might come about.
A Greek-style debt crisis?
Five years ago, Greek government bonds were treated as risk free assets. In May 2007, Greek 10-Year bonds yielded around 4.5%. German 10-Year bonds meantime were trading at yields of around 4.3% that same month.
Granted, this is a snapshot of one brief period, but it illustrates a point: Greek bond yields were not pricing in any of what was about to happen.
That changed, and it changed very quickly. This is what tends to happen in a debt crisis - there is a sudden reappraisal of a borrower's creditworthiness. The amount lenders are willing to lend goes down, while the rates a borrower needs to pay goes up. Suddenly, it becomes harder to roll over debt, and harder to borrower on sustainable terms.
The factors that can prompt this "sudden reappraisal" include:
A growth shock, since it makes debt repayment and servicing harder;
A sudden rise in levels of debt, since it too makes repayment harder and default more likely;
A general rise in investor risk aversion, since they are likely to favor safer assets and prioritize getting their capital back over how much it might grow.
Greece, as is often the case, was hit by all three at once.
Britain, with a much longer debt maturity profile than Greece, remains a long way from that scenario. Or so we would like to think. In truth, though, sluggish growth and rising sovereign debt levels are moving us closer than we would like.
So far, though, UK gilts have continued to be regarded more-or-less as a safe haven, with yields hitting record lows this year (we will leave for another day the reasons why this might be, and how justified and sustainable is this phenomenon).
Britain has a key advantage over the likes of Greece (and Ireland... Portugal... Italy...Spain... The Netherlands... France... etc.). An ace up the sleeve: monetary sovereignty.
But is this a game where aces are high or low? That depends on whether we end up with the second nightmare scenario.
Britain "wins" the currency war
The first two measures for repaying debt (growth and higher taxes) look to be a busted flush for the foreseeable future. While gilts continue to be regarded as a risk-free asset, the third measure (more borrowing) remains viable. But if Britain pushes its luck, it could find one day that investors take a look at its debt levels, compare them to its growth rate, and all decide they want to be first to the exit.
It therefore seems reasonable to expect that measure four (inflation) will take up a greater-and-greater share of the debt "repayment" work - especially if the British government gets serious about reducing borrowing levels (a sizeable 'if', admittedly).
The Bank of England has so far done a reasonably good job at achieving its main goal since the crisis began. Yes, you read that correctly. The bank's primary goal, you see, is no longer price stability - at least not in this observer's view. It is to prevent a banking crisis by ensuring banks have access to enough liquidity to keep things ticking over. The most obvious first step was to cut interest rates to historic lows, which the Bank did.
But it went a lot further. To see what I mean, take a look at the following extract from one of the Bank's numerous papers on the impacts of quantitative easing (I'm quoting quite a big chunk to give you a feel for all the different liquidity measures the Bank has introduced:
"Large-scale asset purchases in the United Kingdom were a culmination of a package of measures designed to address the consequences of the financial crisis. These measures included the provision of enhanced liquidity support, measures to enhance market functioning and QE or large-scale asset purchases...The provision of liquidity support was centred on the £185 billion Special Liquidity Scheme introduced in April 2008, which allowed banks to swap mortgage-backed securities and other illiquid assets for Treasury bills. A Discount Window Facility was also introduced to meet the short-term liquidity needs of financial institutions requiring assistance. In addition, there was the assurance that the Bank of England was ready to offer emergency liquidity support at a penalty rate and against a broader range of collateral to otherwise solvent financial institutions that were experiencing liquidity problems."
The above was all pre-QE. That was still to come:
"To address market functioning, an Asset Purchase Facility was created to allow the Bank of England to purchase high-quality commercial paper and sterling investment-grade corporate bonds. Before the QE policy was introduced, these purchases were financed by the issuance of Treasury bills and the cash management operations of the Debt Management Office. Like the offer of emergency liquidity support, the knowledge that the central bank was now in the market for these assets may have improved overall market functioning."
It is perfectly understandable that the Bank should seek to forestall a banking crisis by ensuring the system has sufficient liquidity. But these measures are not cost-free.
On the eve of the crisis, the Pound was trading at around $2. It has fallen sharply since. Admittedly that is a rather artificial comparison; $2 is right at the top end of the range over the last 25 years, and most currencies have suffered against the Dollar since the crisis started, as many investors have viewed the Dollar as a safe haven.
But consider the Pound against the Euro. When the crisis began in mid-2007, the Pound was trading just below €1.50. It then fell to nearly €1.00 in early 2009, and has never been higher than €1.25 since - despite everything that's happened in Europe. Why?
One reason could be that the Bank of England has been more successful that the European Central Bank at signaling its willingness to issue liquidity in the event of a crisis. Depending on your point of view, you might say this shows the bank has done a better job of performing its lender of last resort role. Or you might say it's done a better job of debasing the currency.
In a lot of ways, they are the same thing.
The implications for gold
One way of looking at gold's long run price behavior is to view it not as a commodity, but as a currency. Gold's bull market over the last decade or so can thus be viewed as one currency (gold) gaining value against its central bank-issued counterparts.
As we have noted before, gold's day-to-day moves - against all currencies - tend to be determined by what is happening with the Dollar. But over a longer period, it makes a significant difference against which currency you measure gold.
With Britain mired back in recession, prospects are slim that the Bank of England will consider a move away from its current accommodative stance any time soon. That will weigh on Sterling.
British investors who made a gold investment early in this crisis have seen their decision to ensure themselves pay off. As the crisis drags on, though, the need for a hedge has not gone away.