Posted Oct 3, 2022, 6:07 PMUpdated Oct 3, 2022, 6:15 PM
It was a sigh of relief from the markets that greeted the British government’s about-face on Monday morning. Prime Minister Liz Truss and her finance minister, Kwasi Kwarteng, have backed away from scrapping the highest income tax bracket, which targets the wealthiest taxpayers. This measure was the most controversial of the “mini-budget” presented ten days ago.
The publication of this program providing for several tax cuts and subsidies to fight against the rise in the price of Energy – all financed by debt – had propelled the British 10-year rate beyond 4.55% , and caused the pound sterling to plunge close to parity with the dollar. The Bank of England had to intervene urgently, in particular to save the pension fund sector.
The beginning of a return to budgetary reason conceded on Monday morning therefore made it possible to ease the pressure. By mid-afternoon, the yield on 10-year Gilts fell 21 basis points to 3.87%. The pound for its part rose to 1.125 dollars, the level at which it was evolving before the announcement of the government program.
This movement of incredible violence, however, leaves a number of questions unanswered.
1. Will the government’s gesture be enough to calm the markets?
At first, yes. “The effects of this decision should not be overlooked,” says Antoine Bouvet at ING. The markets were hoping for a strategic U-turn from the government. But this gesture of goodwill remains quite limited. Dropping the top tax bracket was only £2bn of the £45bn ‘mini budget’. Which means that the UK will definitely increase its funding program by 60 billion pounds this year. Additional debt issues could therefore prove more difficult for the British Treasury, and weigh on Gilt rates.
On the foreign exchange side, mistrust remains. “Market confidence is lost,” warns Rabobank. Currency traders expect further dips in the pound if the government does not overhaul its program. The cost of hedging against a slippage of the British currency by the end of the year is again approaching the highs recorded in June 2016, after the Brexit vote . But neither Liz Truss nor Kwasi Kwarteng seem ready to make further concessions.
The main question is how the markets will react after the end of the Bank of England’s emergency interventions. It has pledged to buy up to £5bn of long bonds per day, but only until October 14.
2. Should we be worried about the UK rating?
It was S&P Global Ratings which fired the first on Friday evening, formally matching London’s sovereign rating with a negative outlook. In other words, the agency foresees the possibility of an eventual degradation of this rating, if the economic situation of the kingdom does not improve.
In support of his decision, the fact that the “mini-budget” will contribute to the widening of the country’s public deficit, of the order of 2.6% of GDP per year on average. And above all that this new budgetary deal will lead to an increase in debt, while S&P expected a drop from 2023.
The symbol is strong, even if the agency still assigns London a rating (AA) one notch higher than that given by its two major competitors. Moody’s earlier in the week raised concerns about the effect of large uncompensated tax cuts on UK credit quality. Hinting that she could officially downgrade her outlook before the end of the month.
And after ? “The question is not whether the United Kingdom’s rating will be downgraded, but how many notches it will go down,” a major European banker told the Financial Times. If the country were to fall into the “A” category, some investors could then be forced to sell their government bonds.
3. Has the UK regulator allowed systemically dangerous strategies to pass?
Were the favorite investment strategies of British pension funds over the past twenty years, the famous LDI (for “liability-driven investment”) “ticking time bombs”, as claimed by Simon Wolfson, the boss of the chain of Next clothing stores, which boasts of having alerted the Bank of England in 2017? Should supervisors have known that a sudden rise in rates exposed the 5,200 defined benefit pension schemes – and by extension, their more than 10 million beneficiaries and their £1.5 trillion under management – to calls for margin of such magnitude that they could lead them straight to bankruptcy?
These complex investment strategies, based on derivatives, have long provided British pension funds with the means to pay pensions due, on time. They did not need to organize their assets so that they corresponded perfectly to their liabilities (in terms of maturities, yield, etc.). The financial engineering of the LDI strategies offered by asset managers such as BlackRock, Legal & General IM or Insight Investment provided for this.
Their vulnerability came to light last week when UK long-term market rates jumped after the announcement of the ‘mini-budget’. With strategies becoming big losers, margin calls soared. Pension funds, which did not have enough “cash” to finance their positions on derivatives, then offloaded their most liquid assets – Gilts but also equities – to bail themselves out, thus amplifying the sell-off. .
4. Does this call into question the ongoing global monetary tightening?
Should this be seen as a strategic shift? The Bank of England’s decision to bail out Britain’s debt could be interpreted as the first wedge driven in central banks’ determination to fight inflation. But the Bank of England should still hit hard with its next rate hike, in order to counter the inflationary aspects of the government program. On the Old Continent as in the United States, the forced rate hike should continue, even if this high pace of monetary tightening is likely to favor new shocks on the bond market.
On the other hand, the desire of central banks to deflate their balance sheets (quantitative tightening), the weight of which has reached record levels due to the measures adopted to support the economy during the Covid crisis, has taken a hit. The BoE, which was supposed to start selling some of the bonds it has in its portfolio this month, has postponed the maturity date to 1er november. The US Federal Reserve, for its part, is struggling to keep up the pace it has set itself. The ECB has not yet taken the decision to let expire without reinvesting part of the securities it has purchased. It should raise the issue during its meeting on October 27, or even on Wednesday, during an informal meeting of the Board of Governors.
She might prefer to wait. These liquidity-absorbing operations could in fact result in a sharp increase in volatility on the bond market. And more broadly, perhaps excessively amplifying the rise in financing costs induced by increases in key interest rates. “The example of the Banque d’ could encourage other central banks, and in particular the ECB, to think twice before supplementing their ‘traditional’ action on rates with quantitative tightening”, underlines Gilles Moëc, Chief Economist of the AXA Group.
5. In an environment of extreme volatility, what is the risk of contagion from a single event like this?
The extreme pressure on British rates quickly affected all debt markets last week. When the yield on the British 10-year Gilt (government bond) soared by more than 40 basis points on Monday, that of the German 10-year Bund tightened by more than 20 basis points. As for the American reference rate of the same maturity, it climbed by 24 basis points. No offense to Kwasi Kwarteng, UK markets are not splendidly isolated from the rest of the planet. First, the City is one of the main financial centers in the world. Then, the “cable” (the pound against dollar parity) is the third most traded pair on the foreign exchange market.
The contagion was all the stronger as the bond market suffered its worst correction in a long time this year. Volatility on long-term rates is extremely high. BofA’s MOVE index, which measures implied volatility in the US bond market, is moving at levels comparable to the Covid crisis in March 2020 or the post-Lehman period of 2008-2009.
Extreme nervousness that risks being fueled by investor concerns. Some of them fear that the UK is the canary in the mine. They believe that with the rise of populism, it is now difficult to completely rule out the risk of a “Kwarteng-like” storm in another developed market.
