Do you remember Laurel and Hardy? Side-splitting slapstick comedy from two talented clowns, their sketches ending with hilarious calamity and the punch line, “Well, here’s another nice mess you’ve gotten me into!” But the irony was that they were equally complicit in creating that mess.
I’m so grateful to Kwasi Kwarteng and Andrew Bailey for reminding me of this talented comedy duo. Because thanks to their mishandling of financial markets, we are in a fine mess and elsewhere in the world, everyone is laughing. The UK’s Chancellor of the Exchequer and the Governor of the Bank of England are not usually associated with such antics. Both have had a humiliating lesson in the laws of unintended but nevertheless predictable consequences.
The crisis has culminated in the Bank of England printing £65 billion in order to bail out the LDI market by buying long-dated UK government debt (gilts). LDI stands for Liability Driven Investment, a strategy that is a major component of the financial plumbing that sits behind the funding of UK pension payments.
This isn’t a cue for you to panic, which seems to be the primary goal of the mainstream media. What has happened will certainly make things more difficult for the UK economy than they needed to be, but the problems are not insurmountable, provided that politicians and policymakers get their act together. Speedily.
The Background Problem
The current crisis has been germinating over the last 12 to 18 months. The global economy was recovering much more strongly in the aftermath of the primary phase of the Covid-19 pandemic and inflationary pressures were building. At the same time, governments (particularly in the US) were still spending heavily (fiscal stimulus) to accelerate the rate of recovery.
Central banks had kept the cost of money historically low through artificially low interest rates and quantitative easing. Rising prices and a tight labour market should have encouraged a policy reversal sooner. Found to be behind the curve, central banks have been trying to catch up. In the US, interest rates have risen 5 times in the last 6 months; from 0% to 3%.
Sterling’s decline is not as much about us as we like to think it is. The real story is the strength of the US dollar against all currencies. For example, the Chinese renminbi, the euro and the Japanese yen have declined by around 10%, 15% and 20% respectively against the US dollar this year to date. The reason is that the extremely buoyant US economy is not slowing down quickly enough in the face of steadily rising interest rates – and an increasingly hawkish US Federal Reserve. Investors in dollars are told to expect further steep increases in interest rates, so why bother buying other currencies?
Year to date, sterling has declined in value by around 20% against the US dollar. 15% of this decline is the result of the rise in value of the dollar. Only the most recent 5% decline is the result of the UK’s recent policy ineptitude.
The Banana Skin
During the week before the Mini-Budget, the Chancellor announced that the new government was planning a change in macro-economic strategy in an attempt to stimulate a higher level of trend growth and trailed the primary (most expensive) tax cuts that he planned. Financial markets seemed anxious about these plans, on the basis that additional government borrowing would inevitably be necessary in the short term. However, it was not a total surprise because Liz Truss had fought her leadership campaign on this agenda. Financial markets were clearly expecting more detail about how the tax cuts would be paid for in the longer term.
Mr Bailey and his colleagues showed a complete lack of empathy for financial markets when, the day before what was clearly going to be a controversial event, they announced a seismic shift in their own policy. The UK economy has been supported by 14 years of quantitative easing since the financial crisis, facilitated by £875 billion of gilt and corporate bond purchases by the Bank. What were they thinking when they decided it was a good idea to put this in reverse the day before? In essence, they were signalling that they expected financial markets to stump up £80 billion over the next year, to buy the gilts that they planned to sell.
The next day provided a bombshell. Mr Kwarteng announced £45 billion of unfunded tax cuts. In other words, he indicated that he was expecting financial markets to give him an extra £45 billion a year. This was on top of the Bank of England’s demand the day before (£80 billion) and on top of the up to £150 billion that would need to be borrowed to pay for the (this was at least necessary) energy price guarantee schemes for households and businesses. Did I mention the £75 billion or so that we would have borrowed anyway?
There was no independent scrutiny of the figures by the Office for Budgetary Responsibility (OBR) and there was no Treasury assessment given regarding the likely impact of the additional borrowing on the UK’s finances.
School Boy Error
Over the weekend, the Chancellor gave a series of interviews and cheerily announced that there was even more to come in terms of tax cuts.
So, financial markets were expected to dig deep to fund our inability as a nation to live within our means and to have blind faith that in due course, there would be a plan to pay off what we borrow. And to understand what I mean by ‘financial markets’, it is useful to remember a former Governor of the Bank of England who said that the UK depends upon the kindness of strangers. ‘Financial markets’ means primarily overseas investors, who clinically cast their slide rule over the UK to decide whether we would represent a good investment.
The Push Back
The conclusion on Monday morning was “Not at this price”. The pound fell, but more alarming was the fall in the price of UK government debt, particularly long-dated securities. Mr Kwarteng announced that he wasn’t concerned about how financial markets reacted, which added fuel to the flames. I am reminded of the expression, “Don’t bite the hand that feeds you”.
The Doom Loop
Which brings us back to LDIs. Think of a big UK company and they probably have a defined benefit/final salary pension scheme. Most are now closed to new membership but they nevertheless represent trillions of pounds of assets that underwrite the pension payments of millions of current and future pensioners. Investment strategies for these funds are necessarily conservative and heavily involve gilts because of the predictability and security that they traditionally offer. Until this week.
Most pension schemes use a large core of gilt holdings to match anticipated pension payments and then leverage the security of such investments by using them as collateral to finance some exposure to riskier long-term assets, that will hopefully provide a better return. The massive sell off in long-dated gilts meant that their collateral value declined, forcing pension schemes to sell other gilt holdings. This further depressed prices and created a ‘doom loop’ similar to the one that ended Lehman Brothers in 2008 and triggered the global financial crisis.
The Bank of England has since saved the day by restoring order to that market by using its funds to buy long-dated gilts and stabilise their prices. It shouldn’t have come to this. Mr Bailey has a long career as a financial regulator, both at the Bank of England and the Financial Conduct Authority. He should have known better. Prior to becoming an MP, Mr Kwarteng was a financial analyst for one of the UK’s most successful hedge fund managers. He would have had first-hand experience of how brutal, unforgiving and opportunistic financial markets can be. He should have known better.
Further down the line, there may be some uncomfortable questions about how much money his former employers made by shorting the pound over the last few weeks.
It’s such a shame really. There were some good ideas in the Mini-Budget when you dig deeper into the largely unreported detail but I am concerned that the notion of ‘going for growth’ has been discredited before it got started. Something needs to be done to shake the UK economy out of its long term malaise, but politicians need to work with financial markets, not attempt to dictate to them.
Let’s hope that things improve over time and take some comfort from the fact that most of our investments are outside these shores. This has provided a useful cushion for PMW portfolios.