Gilts set to wilt in inflationary heat

The gilt market is set for some stormy weather as the new year unfolds, so get your umbrellas ready, says Teresa Hunter

What a corker of an agenda awaits us at the start of this New Year. As if Tony Blair before the Chilcot inquiry wasn’t dramatic enough, there are the little matters of the Bank of England dismantling the funny money machine, and a general election looming.

While the Blair affair may prove less of a curtain raiser given the juicier bits are likely to be held in private, the other two should get interest racing, or to be more precise, gilt yields.

Ah yes. Gilts. Those plucky little bulls which have stormed ahead for the past 15 years, causing major headaches for those managing and funding pensions. At some point, though, all runs reverse.

Before Christmas, gilt prices began to wobble in the wake of the pre-budget speech, when Government largely ducked the debt issue. That wobble will be nothing compared with what could happen at the end of January when the Old Lady withdraws her programme of quantitative easing.

I hope Santa Claus dropped a giant umbrella down your chimney this Christmas. Get ready to open it up fast. This next wobble could be akin to a 26 stone woman in a G-string bikini jump off the top diving board at a swimming pool. We’re in for one helluva splash.

But a good soaking for gilts could be just what the doctor ordered for the pensions industry, which has been taking a bath for more than a decade.

Pension funds and insurance companies selling annuities are big buyers of these gilts, because they guarantee a return. A bull market bites them where it hurts.

Governments issue gilts or sovereign bonds to fund their borrowing, and there has been no shortage of stock around. Yet prices have held up, choking yields. The UK alone borrowed a tad short of £180bn last year, and plans to do the same in the coming year, by issuing gilts.

Other buyers are overseas investors, which these days largely means the Chinese. Confucius said he who will not economise will have to agonise, and we could be heading for a Chinese burn.

It’s delayed pain. Over the past year, the Bank of England has been shelling out gilts with one hand, but buying them up again with another using its magic money machine. This has supported gilt prices and kept yields down.

Undoubtedly, this has had a distorting impact on pension funding and annuity prices, and created a false market which will shortly come to an end. The Bank is poised to buy up a further £25 billion in January, but then stop. The Monetary Policy Committee meets again in early February. Unless it decides to take alternative action, crunch time will come with the next gilt auction, when we discover what price overseas buyers are prepared to put on UK Government promises.

The expectation is gilt prices will tank, pushing yields up sharply, as real investors demand a significantly higher return to bet on UK PLC.

Many market watchers believe the heyday of gilts is over. As in the 1970s, when Government struggled with mountains of debt, questions over national credit ratings and inflationary pressures, there will be more rewarding places to put your money.

As such, the cost of buying out pension promises either via annuity or other mechanism will fall, easing the teeth-tingling challenges facing many funds, employers and individuals saving for their retirement. Even inflation can have a silver lining, although not for those already receiving a pension.

It could be one way of inflating our debt away, while addressing the intergenerational unfairness which sees some cohorts take significantly more out of schemes than another group just a couple of years younger, due to changes in benefits and accrual.

The problem with inflation is once out of the box, it’s hard to get the lid down again. As Confucious said: “I just shot an elephant in my Pyjamas. How he got in my pyjamas I’ll never know.” Now I think about it, I’m not sure that was Confucious.

Teresa Hunter is personal finance editor of Scotland on Sunday