The UK has not usually been known for economic orthodoxy. Yield curves can be inverted for years. Asset values bear no relation to asset replacement costs. Government has foreseen closing down its own funding market. We never saw anything impractical about switching from industry to fund management as an important component of our GDP.
These are all situations we have created ourselves.
We cannot blame Brussels, although Brexit may yet have an uncomfortable effect on the last.
Since 2008 we have nurtured the inversion of Gilt yields and inflation. We target 2% inflation otherwise the Bank of England governor has to go and sit on the naughty step while he writes a letter to the Chancellor of the Exchequer. Gilt yields remain stubbornly below inflation. A Gilt investor loses money from the day the investment is made.
The fall in Gilt yields has several causes. Pension funds were encouraged to buy Gilts to bring certainty to pension payments long before Quantitative Easing, and since that monetary trick commenced banks have become required to hold material amounts of Gilts against deposits and loans.
The death of QE is rumoured. We are on alert for the effect of that. Will Gilt yields alone rise? To what degree will corporate and personal loan rates rise? Will the yield rise contaminate other asset markets, financial and physical? Will the rise shrink those arithmetic pension deficits?
But to where should they rise? A simple spreadsheet calculation recommends 30 year yields of 3.2%+ (1.9% at time of writing), and 10 year yields of 2.2%+ (1.444% at time of writing) if we are to have faith in the 2% CPI, but why should we?
The change to CPI (CPIH 2.7% in Dec 2017) is recent in the UK where we had long used RPI (4.1% in Dec 2017). CPI conforms us to international measurements, but UK inflation has rarely conformed to other nations inflation.
As we knew long before the Brexit referendum: the UK economy is not in step with the EU economies. We are a nation of homeowners by fact or aspiration, and we are reliant on occupational pensions. Even the government does not believe we should rely on state pensions which would be the norm in our major EU neighbours and it is now enforcing occupational pensions on the smallest of employers. We are dependent on mortgages while our neighbours often rent.
And is the measure valid: I lived in South East throughout the years when Margaret Thatcher assured us RPI was about 4% but our SE England rate of inflation was far higher: I estimated nearer 8%. This implied that somewhere within the UK economy was depreciating although I could never find that place in the statistics, but it was most obviously the North East. Nor could I find our high inflating enclave. My start point remains to believe RPI understates, and CPI therefore understates further.
And so what yield should an investor expect from Gilts, and what is the risk they demand it as the UK is prised from the larger and economically more stable EU? The result to that argument will probably emerge as an unforeseen shock. A domestic investor can do simple inflation arithmetic to get to a zero-risk yield. The foreign investor, those friends of Mr Carney’s must add the forex risk.
Whatever the result, it needs to cover real inflation, however measured.
