UK government bond yields continue to rise – February update

I continue to monitor the 10 year government bond yields of three countries (Australia, United Kingdom and the United States) to try and understand when interest rates may start to rise with my datasets shown in today’s chart.

Since June of 2009 the 10 year Australian bond prices have actually fallen by a relatively small 0.5%. In contrast the US 10 year has risen by 7.4% and the UK 10 year by 13.8% to be 4.20% today.

I’m going to update why I think the United Kingdom bond (gilt) yields continue to rise:
Reason 1. The Bank of England have now made clear that they are going to hold interest rates at 0.5% even though inflation is well above target. They have even mentioned that they could yet perform more quantitative easing (QE) which must be inflationary. In the letter to the Chancellor the Bank of England claims that ‘the direct effect of the short-run factors on inflation should be only temporary’ and that ‘although it is likely to remain high over the next few months, inflation is more likely than not to fall back to target in the second half of the year...’. I can’t help but feel that the Bank will ignore their inflation target of 2% and that it’s a case of do as I do not as I say given that the Bank of England’s pension fund has 88.2% of its assets devoted to Index-linked gilts. The market is starting to think the same thing and so to ensure a sensible real (after inflation) yield the prices have to fall and yields rise.

Reason 2. Alistair Darling has forecast government borrowing to be £178 billion. On Thursday last week yet another record was set when it was announced that in a month when tax receipts usually flood in the government still had to borrow £4.34 billion. This is the first time since 1993 that the government has had to borrow in a January. Punters are now starting to suggest taht at current trends the government deficit could be £10 billion more than forecast. Supply and demand principles should hold. More supply of debt for purchase should reduce the price of debt.

Reason 3. The UK government are still yet to explain how they are going to reduce the levels of borrowing. The levels of borrowing are heading to 13% of GDP and may even exceed that of Greece which we have seen so much of in the press lately. How long until the credit worthiness of the UK is downgraded. This will depress prices meaning yields will have to rise.

Reason 4. Those who already own government bonds and can see what’s happening will start to sell their holdings. This combined with the Bank of England now out of the market and no longer buying debt through QE has to reduce the number of buyers. Again supply and demand should prevail pushing yields higher.

So what does this mean for my retirement investing strategy? Exactly where I was last month. If I owned gilts I’d be considering selling. I don’t own fixed interest gilts so I’m ok here. I do own index linked gilts but with inflation kicking off I’m comfortable with this and following the Bank of Englands pension fund.

I also will continue watching house prices carefully. The interest rates on mortgages have to rise as those wanting to borrow for a house will effectively be competing with the UK government for funds. I can’t see how house prices can continue to rise with increased borrowing costs and this could turn out to be the catalyst that brings on a reduction in house prices.

As always DYOR.

Assumptions:
- All yields are month end except February which is 18 February 2010

Gold Priced in GBP – February 2010 Update

I am currently forced to buy gold priced in GBP for my retirement investing strategy as this is where my earnings from employment occurs. I t therefore makes sense to look at how gold has performed over the years priced in local currency.

At the time of writing this post the announcement has just been made that the government’s net borrowings for January are dire at £4.34 billion compared with last year’s surplus of £5.3 billion. This looks to have caused the GBP to weaken to 1.557 to the USD and even with the International Monetary Fund (IMF) declaring that they intend to sell 191.3 tons making gold priced in GBP to be currently £715.57.

In absolute terms gold has never been this expensive when looking back over historic average monthly data since 1979. However there has been a lot of inflation over this period and so as always I will look at the real (inflation) adjusted price of gold over this period which is my chart today. The inflation dataset that I will use is the UK retail prices index (RPI).

This chart shows a very different story. Since 1979 we have seen two higher real peaks. The first was £840.89 in 1983 and the second was £1043.39 back in 1980. These peaks are 18% and 46% higher respectively than today’s price suggesting that there is still plenty of potential upside.

The trend line of the chart suggest gold today at only £248.20 and the historical average real gold price from 1979 is £429.50. So by both these measures gold looks over priced in GBP terms.

History suggests that gold has significant potential upside from its price today and given that I am underweight gold against my desired low charge portfolio I think I am going to buy some more. I will of course update the blog when this occurs.

As always DYOR.

Assumptions include:
- Last Gold price actual taken on the 18 February 2010
- All other prices are month averages.
- February ‘10 inflation is extrapolated.

Australian Stock Market – February 2010 Update

To try and squeeze some more performance out of a retirement investing strategy that is heavily focused on asset allocation I am using a cyclically adjusted PE ratio for the ASX 200 to attempt to value the Australian Stock Market. The method used is based on that developed by Yale Professor Robert Shiller. I will call it the ASX 200 PE10 and it is the ratio of Real (ie after inflation) Monthly Prices and the 10 Year Real (ie after inflation) Average Earnings. For my Australian Equities I will use a nominal ASX 200 PE10 value of 16 to equate to when I hold 21% Australian Equities. On a linear scale I will target 30% less stocks when the ASX 200 PE10 average is ASX 200 PE10 average + 10 = 26 and will own 30% more stocks when the ASX 200 PE10 average is PE10 average -10 = 6.

Chart 1 plots the ASX 200 PE10. Key points this month are:

ASX 200 PE10 = 18.2 which is down from 18.8 last month. My target Australian Equities target is now 19.6% which is up from 19.2% last month.

ASX 200 PE10 Average = 22.8

ASX 200 PE10 20 Percentile = 17.3

ASX 200 PE10 80 Percentile = 27.7

ASX 200 PE10 Correlation with Real ASX 200 Price = 0.81

Chart 2 plots further reinforces why I am using this method. While the R^2 is low at 0.1433 there appears to be a trend suggesting that the return in the following year is dependent on the ASX 200 PE10 value. Using the trend line with a PE10 of 18.2 results in a 1 year expected real (after inflation) earnings projection of 13.3%. The correlation of the data in chart 2 is -0.38.

Chart 3 plots Real (after inflation) Earnings and Real Dividends. Dividends and Earnings both remain below the trend line. Earnings also remain very close to that of Dividends. What this means is that currently Australian companies are using nearly all their Earnings just to fund the Dividends. Yet the trend line suggests typically clear distance between the two with the trend lines running almost parallel. I ask the same question as last month. Where is the money for investments going to come from?

As always DYOR.

Assumptions include:
- All figures are taken from official data from the Reserve Bank of Australia.
- February price is the 17 February ’10 market close.
- February Earnings and Dividends are assumed to be the same as the January numbers
- Inflation data from January to February ’10 is estimated.

“How Lloyds TSB is helping first time buyers”

I was amazed but unfortunately not surprised to see the methods that Lloyds TSB (which is being propped up by my taxes) is using to try and cajole first time buyers into the UK housing market. The product being peddled justified a four page advertisement in a major London newspaper and is called the Lend a Hand Mortgage.

The advertisement starts with “as a response to the current market conditions, the Lend a Hand Mortgage is giving first time buyers the opportunity to get help with their mortgage from family and friends.” From what I read it doesn’t look like that great a deal to me.

Lloyds claim that “in 1999, 592,000 first time buyers completed mortgages, by last year it had fallen to 193,000, according to the Council of Mortgage Lenders,” My chart today demonstrates clearly one of the big drivers of why this has occurred. For the year 1999 the ratio of Nationwide Historical House Prices to the Average Earnings Index (LNMM) was an average 742.7 and in 2009 this had risen to 1139.1. That means affordability has reduced by 53%. This un-affordability has been caused by the very same banks that are creating products like that advertised extending ever easier credit which is what put us in the current mess we are in today.

The mortgage advertisement goes on to say “even as recently as a couple of years ago, it was much easier to get a mortgage... and it was not uncommon to get a 100% mortgage that didn’t need a deposit.” As we all now know that was just foolish. I’m still amazed this occurred. If you can’t put together a deposit for a mortgage just how did the banks expect people to be able to afford to repay that mortgage. Additionally the banks were counting on property never decreasing in value plunging people into negative equity. Even the most naive banker by spending 10 minutes on the internet could have found historical data that showed how false this assumption was.

Some more data provided in the mortgage advertisement states that “according to the Council of Mortgage lenders, in July last year 80% of first time buyers were turning to their parents for help, up from 50% in February.” To have included this Lloyds clearly think that this adds to the sell. What’s it saying? Everyone else is doing so you should to? Personally I find that a terrible statistic and quite sad. House prices are so over valued compared to earnings that it is almost impossible for a first home buyer to buy a roof to put over their heads without external support. Basic human needs are food, clothing and shelter. Now we are in a situation where one of the basic human needs is now unobtainable without support. What type of country are we living in?

So how does this product work? Let’s say you want to buy a house for £100,000. As the first home buyer you offer up 5% (£5,000) worth of deposit and your ‘helper’ offers up 20% (£20,000) which is placed in a savings account earning rate of 4.15% for 42 months. Then by magic the first home buyer is able to be given a mortgage of 95% (£95,000) at 5.69% fixed until March 2013 if you don’t pay a product fee (whatever that is). Let’s analyse this a little:
- The ‘helper’ gets their money back after 42 months “provided the buyer doesn’t default on their mortgage payments, and provided the amount of the mortgage compared to the value of the property (LTV) has dropped to 90% or less – as assessed by us...” So Lloyds have cleverly protected themselves from a house price crash of up to 25% for the next 3.5 years by effectively offering a 75% mortgage.
- Should Lloyds have only offered first home buyers the 75% mortgage it would have meant that a £5,000 deposit could have only secured a mortgage of £15,000. Instead, this scheme can leverage the first home buyer up to a mortgage of £95,000 while providing some protection to themselves.
- The mortgage is a repayment mortgage however to demonstrate quickly how much this mortgage benefits Lloyds I’m going to assume an interest only mortgage (ie no principle is repaid). Both final amounts I’ll present would be a little less if calculated as a repayment mortgage although not by much as the principle reduction per year is very small in the early years of a mortgage. Let’s look at what happens in the first year. So the buyer who takes a standard 75% mortgage provides Lloyds with charges of approximately £15,000 x 5.69% = £853.50. Now the buyer who takes a ‘Lend a Hand’ provides Lloyds with charges of approximately £75,000 x 5.69% + £20,000 x (5.69%-4.15%) = £4,575.50.

To me it looks like a continuation of the past:
- The first home buyer ends up over leveraged and indebted for life which is what put us into the credit crunch in the first place.
- Lloyds ends up squeezing more than 5 times the revenue out of the same customer.
The only difference is that this time Lloyds are a bit cleverer and give themselves some more protection than previous times.

I’m not convinced the product is designed to give “more people...a chance to own their first home” more likely a chance for Lloyds to maximise its revenues. I’m remaining out of the house market for now and the more I read about these types of products the more I think current prices are unsustainable.

As always DYOR.

Gold Within My Retirement Investing Strategy – February 2010 Update

Within my Retirement Investing Strategy I currently hold 3.2% (up from 3.1% at the last gold update due to a buy decision made this month) of my portfolio in gold with a targeted holding of 5%. Gold is the only portion of my portfolio that does not provide a yield (dividends, interest etc).

The first chart shows the updated real price of gold since 1968, with the wild ride that comes with gold obvious. This month the real (after inflation) price of gold has risen by about 0.3% to $1,119.40 per ounce. The trend line however suggests a price today of $631.00 which is the same as the last update. The historical average real gold price from 1968 also remains at $600.52. So by both of these measures gold still appears overpriced.

The correlation between the real S&P 500 (also displayed on the first chart) and real gold also holds from the last update at -0.33. The second chart provides the ratio of the S&P 500 to gold demonstrating just how far apart the two can vary. Today this ratio has lowered slightly from 1.01 to 0.96. The trend line however suggests a ratio today of 2.63 and the historical average ratio from 1968 to today is 1.63. So this measure would suggest that if you were looking to choose to buy the S&P 500 or gold then the S&P 500 might be the better option.
The final point to make however is that while both the first and second charts suggest gold is overpriced on historic measures I cannot forget that in 1980 gold reached an average real monthly price of $1,728 which is a long way above where we are today.

My investment methods are largely mechanical and given that I am underweight gold against my desired low charge portfolio I should be buying more. Unfortunately all my earnings are made in GBP and in this currency gold is starting to feel expensive. Of course I would never make a decision based on feel so I’m going to do some historic real gold price analysis priced in GBP before making the decision to buy more. Of course I’ll share this analysis with you over the next few days.

As always DYOR.

Assumptions include:
- Last Gold price actual taken on the 16 February 2010
- Last S&P 500 price actual taken on the 12 February 2010.
- All other prices are month averages.
- Inflation data from the Bureau of Labor Statistics. January and February ‘10 inflation is extrapolated.