Who is looking ridiculous now?
The singer, Adam Ant, once sang that “ridicule is nothing to be scared of.” I think he might have been wrong! For a politician, all kinds of crises can be survived but not ridicule. Once you have looked truly ridiculous on the public stage, you are done for. That leads to the extraordinary situation where the new government, installed only three weeks ago, looks so ridiculous after a revolt from international markets that the jobs of its new Chancellor, and even the prime minister, have been called into question. There is little doubt, appalling misjudgements have led to one of the greatest bond market implosions in history.
What Happened
The price of the current 30-year British bond, or ‘gilt,’ tells the story. From the Bank of England’s scheduled meeting on Thursday 22nd September until the early hours of Wednesday morning, it fell by more than 24%. As a result, the BOE announced it would buy as many long bonds as were needed to restore stability to the market. The price rallied by 24% from its low in a matter of hours. However, it is still down a (massive) 6% since.
What the Bank of England Did
The announcement in the London morning said the Bank was going to buy long bonds “on whatever scale is necessary” to restore orderly market conditions. These purchases will not be sterilized (meaning the bank is not selling something else to balance the market impact), so they will be stimulative. Plans to embark on quantitative tightening or selling off the BOE's massive bond portfolio to push up yields as part of the attempt to tighten monetary policy and combat inflation, were due to start next week. This has now been postponed until Oct. 31.
At least in some sense, this means a return to the quantitative easing (QE) that prevailed after the Global Financial Crisis and entailed buying bonds to push down their yields.
The full statement was a joy for Kremlinologists who follow the Bank’s internal politics. This might look to most of us like a monetary policy decision, but it was not made by the BOE’s Monetary Policy Committee, it was left to the executives who run day-to-day operations to make the call.
The message here is two-fold. First, this was a tactic adopted swiftly by the adults in the room to avert true disaster. The Bank is still the lender of last resort and can fulfil that role without asking permission from a nine-person committee. Secondly, the BOE really wants everyone to treat this move as involving no step back in its monetary policy, and hence no step to accommodate or fall into line with government fiscal policy. However, it is unlikely to be viewed this way.
One could almost suggest we have moved from a situation where market dysfunction is tackled directly by the MPC, which then gives the instructions, to one where the operational arm of the Bank listens to the concerns the FPC has about financial stability and then it acts. These nuances do not matter to the markets. The fact is the BoE decided to buy gilts to calm the markets and that is QE.
Bond and currency markets have reacted so poorly since the mini budget, at least in part due to fears the move added new fiscal stimulus to an economy that already had 10% inflation and a very low jobless rate. It is difficult to see how this perception can be corrected by new monetary policy stimulus. After bond markets rebelled at news of fiscal stimulus and larger government debt issuance, the central bank postponed its plans to reduce its balance sheet, and instead proceeded to expand it by buying government debt. The risk is investors adopt a cynical interpretation being the BOE is enabling the fiscal authority’s spending plans, even as financial markets have sounded the alarm.
Why They Did It
The crisis the BOE stepped in to eliminate was triggered by the speed with which longer gilt yields rose after the government’s “mini-budget,” featured steep tax cuts with no detail of any spending cuts to help pay for them. This had already prompted several mortgage lenders to withdraw new offerings, an alarming incursion on the real world inhabited by most Britons.
The heart of the darkness, however, was in pension plans. As in the global crisis, sharp moves triggered an accident for systemically important institutions that had taken on leverage in an opaquely technical way. It stems, ironically, from an impeccably prudent and conservative reform. For the last two decades, British pensions in the public sector and from large companies offering a final-salary or “defined benefit” on retirement, have been required to match assets to liabilities. Intended to ensure promises to pensioners could be honoured, this in practice, meant pension funds had to buy a lot of gilts, in doing so, successfully bolstering their finances. The following chart comes from the Pension Protection Fund and shows that both in absolute amount of money and as a proportion of their liabilities, UK pensions ended last month in good shape, with assets comfortable enough to meet their promises.
It is probably best to view this as a bullet dodged, rather than a turning point. Traders the world over knew such a sudden and disorderly fall for gilt prices could only have happened if something was systemically very, very wrong. They were right but the BOE dealt with it, and so other markets could also relax a bit although most, if not all, the problems we were worried about at the end of last week remain.
It’s the Politics
Even if some smart bankers in Threadneedle Street have saved us all from a crisis, broader confidence in the UK economy is barely affected. That is because the problem lies in fiscal policy, and therefore, requires a political solution.
Fiscal policy can only be changed by the chancellor and doing so this quickly would be politically fatal. Therefore, plenty of Tory MPs were briefing journalists that Kwasi Kwarteng must lose his job. Others pointed to how closely he is identified with Liz Truss, and how she had firmly shown her intent to make a big tax cut. They suggested that markets would also require the prime minister’s head on a stake.
There are precedents for finance ministers losing their jobs that quickly, but none that I can think of in the developed world. As for the prime minister, her greatest problem may be that there is an obvious alternative. In the hustings for the job in No. 10, former chancellor Rishi Sunak said bond yields and mortgage rates would go up and the currency down if Truss persisted with her plan, and he was proved right.
Truss might offer Sunak a deal something like the one that Tony Blair gave to Gordon Brown — he can be chancellor, and with it, gain total control over economic policy. More or less any deal Truss offered that Sunak could accept would be appallingly humiliating for her, so this is unlikely. The markets would love it though!
Whilst we remain in challenging economic times with the prevailing investment markets continuing to be volatile, these announcements do provide important financial planning strategy considerations. Please speak with a Prosperis Advisor on 01423 223640 or advice@prosperis.co.uk to find out how we can help you.