From David Stevenson, across the river from the City

Dear Money Morning reader,

The Bank of England shocked the UK markets yesterday – by doing nothing.

The Monetary Policy Committee’s decision to hold the base interest rate at 0.5% was hardly news – nobody had expected that to change.

But the Bank’s decision not to extend quantitative easing – ie it’s not going to print any more money for now – was the big surprise. The fear that the Bank will now stop buying gilts altogether drove yields sharply higher (i.e. prices fell).

So what happens next?

Markets had expected the Bank of England to extend its quantitative easing (QE) programme from the current £125bn to the £150bn ceiling endorsed by the Treasury. Some had even expected it to ask for a higher ceiling. So its decision not to ask for any more money at all was a big surprise.

QE involves buying mainly UK government bonds (gilts) from investors. The idea is that the latter end up with more cash in hand. The Bank hopes this will encourage them to invest in riskier assets, helping to lower borrowing costs throughout the economy, and eventually ending up in the pockets of shoppers and home loan borrowers via more bank lending. It’s basically what desperate central bankers do to make money even cheaper when interest rates have fallen as far as they can go.

It's hard to tell if QE is working or not

From the Bank’s perspective, the decision to hold off for now is understandable. The central bank doesn’t know what sort of impact the scheme will have in the longer term. Recent economic data suggests that for the time being, the economy isn’t in freefall any more – and annual CPI inflation is still above the Bank’s target rate of 2%. So taking a bit of time out to consider what’s going on is a good idea.

The trouble is, it’s hard to tell if QE is really working or not. Britain’s banks have dug themselves into such a big hole after making so many bad loans that lending to private individuals is hardly growing at all. Any money raised from gilts they sell to the Bank is sitting in their vaults, while the rest of the Bank’s cash has gone abroad, as overseas investors have dumped their own gilt holdings.

But that’s the picture today. The trouble is, that may not last. If you increase the amount of money sloshing around the system without creating any new things to buy, you risk stoking up future inflation once the banks do start lending again. That’s bad news for government borrowing – if inflation rises, investors will demand higher returns on gilts, forcing up long-term interest rates and killing any economic recovery off before it’s barely begun.

The real problem with Britain's economy

But wait a minute – if the Bank has decided to stop printing money, then why did gilt yields jump? Isn’t this good news for bond investors?

Well, yes and no – and here’s where we come to the crux of the problem – Britain's massive national debt.

The government needs to sell at least £220bn-worth of gilts this year, the biggest fund-raising effort in our national history. That’s just to keep the Treasury’s books balanced.

As long as the Bank was squatting like a gorilla in the gilts market, with a potentially unlimited supply of money, then investors didn’t have to worry too much in the short-term about being able to offload unwanted gilts.

But now, if the Bank is no longer going to be handing out free money, attention turns back to how the government will fund its incredible borrowing requirements. So far the Treasury has got away with it – this week’s gilt auction flogged another £4bn-worth – but things are now likely to get a lot tougher.

There’s already been some rating agency talk that the UK could lose its top-notch AAA credit rating. That would be very bad for gilts, as fund managers who can only invest in AAA-rated bonds could no longer hold them - and also would have to unload their existing stock.

These key investors will need to see some serious slashing in government spending before they back Britain with their cash. But what we’re seeing from No.10 is more the opposite. According to the latest edicts from Gordon Brown, the government’s planning to spend even more money it doesn’t have.

Net result: even more jitters. Andrew Balls at the world’s biggest bond fund PIMCO tells Bloomberg: “we prefer German bunds over gilts” - UK debt suffers from an “unfavourable economic outlook and increased debt supply”. “We’re concerned about the budget deficit,” says Masataka Horii at Tokyo’s Kokusai Global Sovereign Open fund.

Gilts are still a sell

These are the guys who hold the purse strings. They don’t like QE, because as bond investors, they hate inflation; but they also get worried when the governments they lend to don’t seem to care a hoot about running up massive overdrafts. So unlike the Bank of England, they won’t buy UK government bonds until they’re happy that the yield they’re receiving is high enough to compensate them for the extra risks they’re taking on.

And on present government policy, that’s likely to be much higher than the 3.8% that 10-yr gilts are currently paying. Longer-term, UK government bond yields have a long way to fall unless the money printing press is turned off for good, and public spending is slashed.

As UK MoneyWeek editor John Stepek said: “I’ll not hold my breath”. For now, gilts are still a sell.

Until next time,

David Stevenson

Associate Editor, MoneyWeek UK

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Turning to the markets

The JSE all share index closed up 2.16 % yesterday. The gold mining index rocketed 5.15% higher. Resources shot up 2.88%. Banks and financials added 1.16% and 1.15% respectively. Industrials gained 2.04% and the platinum mining index ran up 3.34%.

London’s FTSE100 closed up 0.85%. The Dow Jones gained 0.33% and the Nasdaq added 0.51%.

Tokyo’s Nikkei closed 0.39% up. Hong Kong’s Hang Seng climbed 1.59%.

Brent crude is currently trading at $61.52 per barrel.

Spot gold’s trading at $925.87 and platinum was last quoted at $1,142.00.

And here’s how the rand is performing against the major currencies:
R/$8.20
R/£13.38
R/€11.46