Best of the Week
Most Popular
1.U.S. Housing Bull Market Over? House Prices Trend Forecast Current State - Nadeem_Walayat
2.The Coming U.S. Economic Collapse Will Trigger a Revolution - Harry_Dent
3. Stock Market Crash a Historical Pattern? - Wim_Grommen
4.Global Panic - U.S. Federal Government Stockpiling Ammo – Here’s What We’re Going to Do - Shah Gilani
5.AI, Robotics, and the Future of Jobs - Aaron Smith
6.This is Your Economic Recovery With and Without Drugs - James_Quinn
7.Gold and Silver Price Getting Set To Explode Higher - Austin_Galt
8.The Something for Nothing Society - Lifecycle of Bureaucracy - Ty_Andros
9.Another Interesting Stock Market Juncture - Tony_Caldaro
10.Inflation vs the Deflationary Straw Man - Gary_Tanashian
Last 5 days
Gold Market and the Interest Rate Trap - 27th Aug 14
Stock Market Staring Into the Great Abyss - 27th Aug 14
A Look at the Coming 30-year Inflation Cycle - 27th Aug 14
Forex Trading - Will USD/CHF Rally Above 0.9200? - 27th Aug 14
Europe’s Depressing Economy Dog Days of Summer - 27th Aug 14
How The Coming Silver Price Bubble Will Develop - 26th Aug 14
A Nation of Shopkeepers - Supply-Side (Voodoo) Economics? - 26th Aug 14
Stock Market Bear Tracks Abound In Wall Street - 26th Aug 14
65,000 U.S. Marines Hold up a Mirror to the Economy - 26th Aug 14
Bitcoin Market Provides Clues for Investors - 26th Aug 14
The Key to Trading Success - 26th Aug 14
Will The US Succeed in Breaking Russia to Maintain Dollar Hegemony?... - 26th Aug 14
Even Mainstream Academia Worried about Massive Bubbles in Markets - 26th Aug 14
Iraq and Syria Follow Lebanon's Precedent - 26th Aug 14
Colonization by Bankruptcy: The High-stakes Chess Match for Argentina - 26th Aug 14
Dow Stock Index On The Cusp - 26th Aug 14
Prohibition Laws and Agency Regulations - 26th Aug 14
Will Canadian Regulators be Able to Avoid Final Fatal TSX Venture Exchange (TSX-V) Crash? - 25th Aug 14
HUI Gold Mining Stocks Elliott Wave Projection - 25th Aug 14
Stock Market Uncertainty Resolved With New High - 25th Aug 14
Go Forth Multiply And Replenish The Earth - 25th Aug 14
Dollar Dumping: When Actions Speak Loudest - 25th Aug 14
A Plethora of Currency, Stocks and Precious Metals Chartology - 25th Aug 14
Why Isn’t Fed Monetary Pumping Helping the U.S. Economy? - 25th Aug 14
Myths About Money and Inflation - 25th Aug 14
The Fed Will Raise U.S. Interest Rates in March 2015 - 25th Aug 14
Gold Price Manipulation Still Alive - 25th Aug 14
The Ebola Outbreak: U.S. Sponsored Bioterror? - 24th Aug 14
Instigating War in Europe - Understanding Ukraine in 15 Minutes - 24th Aug 14
LNG Catalysts About to Hand You the investment Opportunity of the Decade - 24th Aug 14
Another Interesting Stock Market Juncture - 24th Aug 14
The West Set Up the ISIS Endgame - 24th Aug 14
Gold And Silver Low Prices Are NOT The Reason To Own Precious Metals - 24th Aug 14
U.S. Housing Bull Market Over? House Prices Trend Forecast Current State - 23rd Aug 14
Inflation vs the Deflationary Straw Man - 23rd Aug 14
U.S. Interest Rate Rise to Occur Mid-2015 According to Fed's Williams - 23rd Aug 14
Bitcoin Price Continuation of a Move up - 23rd Aug 14
Gold and Crude Oil Price on the Verge of Something Big - Hero's Rarely Win - 23rd Aug 14
Oxaloacetate Feeds and GROWS Brain Cells - Alzheimers Cure? - 23rd Aug 14
Gold Rising Interest Rate Fallacy - 22nd Aug 14
Jackson Hole: Myth of the All Powerful Central Banker Continues - 22nd Aug 14
Partying On In The Terror State - Thank God for Nuclear Weapons - 22nd Aug 14
The Something for Nothing Society - Lifecycle of Bureaucracy - 22nd Aug 14
Hitting The ISIS Panic Button In The Middle East - 22nd Aug 14
US Stock Indices 10-Year Consolidation Patterns ... Upside Breakouts? - 22nd Aug 14
Gold and Silver Price Getting Set To Explode Higher - 22nd Aug 14
Deflation's Final Curtain Call - Part II - 22nd Aug 14 - Clif_Droke
Gold Big Picture: Most Important - 22nd Aug 14
How the “Uncertainty Factor” Drives Crude Oil Prices - 22nd Aug 14
Inflation, Interest Rates, and Why You Should Own Gold - 22nd Aug 14
U.S. Interest Rates Can Rise States Fed President - 22nd Aug 14
Why Emotional Discipline is Key to Trading Success - 21st Aug 14
Getting the Most Value from Your “Geriatric Cruiser” - 21st Aug 14
Mafia Boss Claims Stocks A Bubble, Buy Physical Gold and Silver - 21st Aug 14
Outrage! On The Beheading of Our Media Brother James Foley - 21st Aug 14
Stock Market Crash a Historical Pattern? - 21st Aug 14
The Black Box Economy - 21st Aug 14
The Bond Market is taking Advantage of Janet Yellen`s Dovishness - 21st Aug 14
Meet Your Investment Manager - 21st Aug 14
Gold and Silver Trading Alert as U.S. Dollar Soars to New Highs - 21st Aug 14

Free Instant Analysis

Free Instant Technical Analysis


Market Oracle FREE Newsletter

The Biggest lie in Stock Market History Revealed

Gold, Recession, and Why Britain's Winning the Currency War

Commodities / Gold and Silver 2012 Apr 26, 2012 - 01:26 PM GMT

By: Ben_Traynor

Commodities

Best Financial Markets Analysis ArticleDepending 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.

From mid-2007 to last September's peak, Dollar gold prices gained around 180%. Sterling gold prices, however, rose around 260%.

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.

By Ben Traynor
BullionVault.com

Gold price chart, no delay   |   Buy gold online at live prices

Editor of Gold News, the analysis and investment research site from world-leading gold ownership service BullionVault, Ben Traynor was formerly editor of the Fleet Street Letter, the UK's longest-running investment letter. A Cambridge economics graduate, he is a professional writer and editor with a specialist interest in monetary economics.(c) BullionVault 2012

Please Note: This article is to inform your thinking, not lead it. Only you can decide the best place for your money, and any decision you make will put your money at risk. Information or data included here may have already been overtaken by events – and must be verified elsewhere – should you choose to act on it.


© 2005-2014 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in

Free Report - Financial Markets 2014