Something weird has been happening.
UK government bonds (they call them gilts) are suddenly selling like hotcakes.
Here’s a look at the yield on the 10-Year Gilt over the last 5 years. The yield has never been lower. Even German debt is yielding more.
This is a remarkable run for several reasons. For one thing, investors have hated gilts. Back in February 2010, bond guru Bill Gross wrote: “The U.K. is a must to avoid. Its Gilts are resting on a bed of nitroglycerine.”
It’s not that hard to see why gilts are so hated.
According to Fitch, the UK is on its way to becoming the second-most indebted AAA-rated sovereign, right behind the United States.
The size of the British banking system is — are you sitting down? — over 4x the size of the country’s GDP. A series of bank failures a la Iceland or Ireland would theoretically swamp the UK Treasury.
The UK has a monster trade deficit that keeps getting worse.
As for the pound, it’s hardly a global reserve currency that anyone really needs to hold.
It’s trading significantly lower against the dollar than where it was in 2007. Think of how pathetic that is.
In short, the UK has one of the most detestable economies you can imagine.
It’s got no resources, it’s incredibly service-based, and oh yeah, it keeps missing its deficit targets.
And yet! None of that bothers gilt-buyers, obviously.
The health of the gilt comes back to an issue we keep pointing out over and over again, and that’s the fact that the UK borrows in its own currency, which makes all the difference in the world. We talked about this a few days ago, when we compared Swedish and Finnish yields, the latter of which is in the Eurozone, and pays significantly more to borrow.
It may seem like we’re just harping on this issue over and over again, to the exclusion of everything else, but actually this is really the central issue of the day. There are times when bond investors may get worked up over central bank policy, inflation, and all that. But in a time of crisis, the one thing you want to know is whether the counterparty paying you has the ability to pay you back with unlimited funds, and that’s what differentiates a country like the UK (or the US and Japan) from a country like Germany (which at any time has a finite number of euros in its Treasury).
What’s also important here is that the UK example is very instructive to the US situation specifically. For example, people say that the only reason the US can borrow cheaply is that the US is the world’s reserve currency, a condition that’s decidedly not in place in the UK.
Others say that the only reason Japan can borrow cheaply is that it runs a trade surplus, but again, that doesn’t apply to the UK.
The bottom line: If you’re trying to understand the difference between two different entities — in this case why EU countries have such a hard time borrowing, but the US doesn’t — it’s helpful to have a third entity to compare them both too as a frame of reference and understanding. The UK is perfect for this: Understand the demand for gilts, and you basically can grasp the entire crisis.
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