The pound slumped all the way to $1.4550 after demand at an auction of U.K. bonds, called "gilts" because they are gilt-edged, fell short of the amount offered for the first time in 14 years. Investors bid for 1.63 billion pounds of the 40-year securities, less than the 1.75 billion pounds of 4.25% notes slated for sale.
The ability of governments to sell debt as they expand fiscal programs (and increase their budget deficits in the process) in order to boost sagging economies is seen as a crucial element in a government's ability to mitigate the crisis. The concern in currency markets in this instance was that the BoE might need to print additional currency in order beyond what has already been announced to make up any shortfall in sales. Of course, the same potential risks exist for the dollar should failed bond auctions occur in the U.S.
The BoE recently said it would print additional pound notes in order to purchase up to 150 billion pounds of U.K. debt, a monetary policy known as "quantitative easing" or monetizing the debt. The Federal Reserve last week announced its intention to purchase $300 billion worth of Treasuries.
Fed Chairman Ben Bernanke said during a March 15 interview on the CBS news program 60 Minutes that the Fed was "effectively" printing money by using its computer to increase the balances that large commercial banks hold at the Central Bank.
Longer-dated debt is naturally more risky for investors than that of shorter duration because of the risk that higher inflation in coming years will erode a bond's real interest rate and therefore, prices, an especially risky proposition now considering how fast deficit spending is increasing. Today's gilt auction was for 40 year bonds, the longest-dated debt sold by the U.K.
Countries such as the U.S. and U.K. issue debt in their own currencies (dollars and pounds), a situation which makes it adventitious for a government to "inflate its way" out of the debt created when it increases spending and budget deficits. Real interest rates, and therefore the cost of credit, decrease as inflation increases. In contrast, real interest rates rise when deflation is present.
Those who purchase the debt are of course well aware of the potential risk, which is why it is crucial for economies who are expanding their budget deficits to reassure the market of their intentions to rein in spending at the earliest possible date. The Obama administration has recently stated it intends to decrease the U.S. budget deficit, estimated to be between $1.2 and $1.9 trillion in fiscal 2009, in half by the time Mr. Obama's first 4 years in office are coming to an end.
Foreign purchasers of government debt also face a currency risk in an inflationary environment. For example, the dollar could fall sharply if the market became overly concerned that inflation will spike as the Fed prints additional reserve notes in order to fund its own quantitative easing program. The Fed's balance sheet, which has already expanded to just over $2 trillion (from about $800 billion prior to the credit crisis) could increase to $4 trillion as it expands its purchases of a wide variety of credit instruments including residential and commercial mortgages, student loans, auto loans and credit card portfolios.
The U.K. is looking to sell an unprecedented 146.4 billion pounds of debt this fiscal year as Europe’s second-largest economy grapples with its first recession since 1991.