The Bank of England averts a crisis but only for a moment

The BoE has bought the UK some breathing space but, like the QE program, it is time-limited.

The more immediate issue confronting the UK’s central bank, however, was related to the soaring yields as investors fled the UK bond market. The bank noted the risks to UK financial stability from “dysfunction” in the gilt market.

That dysfunction in the financial markets was reflected in the withdrawal of lenders from the home loan market – they weren’t prepared to write loans in such a volatile and hostile environment – and, more immediately threatening, by a prospective crisis in the UK pension fund sector.

The UK pensions market is largely a defined benefit market, with the funds needing to match long-term liabilities with the assets they hold. When rates rise quickly the value of their bond holdings falls while the net present value of their liabilities doesn’t change as materially, threatening deficiencies in the funds.

In the UK that potential problem has been exacerbated by the widespread use of leveraged derivative strategies (called “Liability-Driven Investment” or LDIs) that are used to effectively hedge their liabilities. The LDIs are estimated to represent about £1.5 trillion of assets or, as the Financial Times noted, roughly the size of the entire UK bond market.

The collateral for those derivative positions is largely the funds’ fixed interest securities holdings. As rates spiked they would have been hit with what are essentially margin calls and forced to dump some of their bonds, creating a spiral that could only end in disaster for the funds, the wider market and ultimately the UK financial system.

The BoE referred to the “material risk to UK financial stability” in announcing the resumption of QE. Its intervention has calmed, not just the UK market, where the 30-year bond rate has fallen back below 4 per cent and the yield on 10-year bonds to 4 per cent, but global markets.

In the US, yields on 10-year bonds had broken through 4 per cent last week but traded around 3.95 per cent on Wednesday. The yields on almost all European government bonds fell and even Australia saw an 11-basis point reduction in 10-year yields.

The BoE has bought the UK some breathing space but, like the QE program, it is time-limited.

The UK already has an inflation problem. It also has a trade deficit of more than 8 per cent (and rising) and a budget deficit. The Truss package, which also included price caps on energy that will cost £60 billion over six months, is unfunded and inflationary.

Loading

The BoE, like our Reserve Bank, is statutorily independent of the government and Treasury. It will have to continue raising UK interest rates and it will, as it said, resume its QT program within two weeks.

UK’s monetary policy will be in direct conflict with the government’s fiscal policies, ensuring that the tightening of monetary policy will be greater than it would otherwise have been. Interest rates on home loans and business finance could be punitive if Truss and Kwarteng don’t back down or come up with some funding for their splurge.

The markets’ rout in response to their package was effectively a vote of no confidence in their economic management and the return to the largely discredited “trickle down” supply side economics of Thatcher and Reagan.

It’s not just the UK’s economy that is at stake in the UK’s response to inflation, an acute energy crisis and a slowing economy.

The way the seizures in the UK markets spilled into international markets underscored how interconnected and fragile they are. A seemingly isolated “event” in one jurisdiction can quickly have ramifications elsewhere as global capital flows and strategies are abruptly disrupted.

The US Federal Reserve Board’s rapid and large increases in US interest rates and its own big QT program has out-stripped the responses of other central banks, with the gulfs in monetary policies widening monthly.
That has resulted in the US dollar strengthening dramatically, exporting inflation to the rest of the world and shifting capital flows towards the US. (China’s yuan fell to its lowest level against the dollar since 2008 on Wednesday).

With the global economy on the brink of recession as central banks try to bring raging inflation rates under control and the Fed’s policies generating volatility and exposing liquidity issues in some financial markets, the global financial system is looking increasingly fragile and vulnerable.

The events in the UK over the past week have provided a glimpse of what a misstep by policymakers might produce in this environment. It wasn’t pretty.