A toxic mix of politics, inflation, and higher welfare rates is endangering the economic system in the UK, sending a shock wave through global markets and providing a warning to the state regarding the dangers of the latest economic era we are entering.
Superlatives are a dime a dozen in demand reporting, but the ructions in the past week are truly great. As nicely as big swings in the pound, the longest-dated gilts, which grow in 50 years, lost a third of their value in four days.
They then leaped in value by more than a quarter in a day after emergency bond-buying by the Bank of England prepared to stop a cycle of forced selling by pension funds. For context, the previous big moves over four days had been half as big, and the bigs daily gain was 15% when pandemic lockdowns shut down the economy.
Such big moves directly impact world markets, pushing up the dollar and Treasury yields and hitting stocks and commodity prices. The crab call took another leg down.
London’s position as a significant financial center and base for global investors, plus the sterling-dollar exchange rate’s position as the world’s third most-traded coin pair, usually gives it an outsize influence on global markets. But there’s also a greater worry Maybe the UK is the canary in the coal mine, giving notice of risks that other advanced needs face too.
The dangers are threefold. In the brief run, is the UK a special case or just the first target of the newly-awakened bond avengers (investors who punish spendthrift governments with higher borrowing costs)? In the lengthy run, is the UK again taking to an extreme approach—loose fiscal policy and more inflationary pressure—that sets to become the new normal?
Yet, the old saw has it that the Federal Reserve walks rates until something cracks. The Fed’s part in all this is that its shift to much higher rates helped the dollar to soar, hitting the sterling and lifting global rates even before the tax-cut-driven selloff. Something shattered, and perhaps other items fall over too.
To manage short-term issues, start with what went wrong. The trigger was the government’s shock unfunded tax cut, to the tune of about 1.8% of GDP a year, with the well-off helping the most. In the grand scheme of things, it isn’t that much. But the cut had such a big impact because of the more general background of skyrocketing interest rates, high debt, dire communications, and the erosion of the country’s institutional credibility. Most of those issues apply, to a more prominent or lesser degree, across the developed world.
The UK events, applying an emergency £65 billion intervention by the Bank of England last week, doled out in daily injections of £5 billion until October 14 to halt a collapse of the bond market, are a case in point.
The crisis centered on assistance funds. In the past, these accounts existed able to fulfill their penalties by funding long-term government bonds of 10- and 30 years, known as gilts, confident they were able to secure an adequate rate of return. But the initiation of quantitative easing after 2008, mixed with central bank interest rate cuts, meant that bond yields fell to historic lows.
To meet their responsibilities in situations where their conventional sources of income were drying up, pension funds had to undertake investments in riskier assets such as corporate credit, equities, and property to meet their liabilities.
They aimed to evade their risks from such assets through economic market functions via derivatives. They borrowed funds for this purpose using their holdings of government bonds, regarded as the safest of all assets, as collateral.
However, the cost of bonds plunged following the Tory government’s mini-budget of September 23, which cut taxes on the companies and the super-rich to the tune of £45 billion, financed by an increase in government debt of £72 billion. So the value of the collateral fell, and the assistance funds faced margin calls from their lenders.
This led to a further bond selloff as the funds sought to meet these demands, exacerbating the plunges in bond prices and leading to demand more collateral. Had this case continued some 90 percent of pension funds, holding £1.5 trillion of assets, could have been caused insolvent.
Like all crises, this one had its national forms. But the concern being voiced in the final analysis is the outcome of global processes.
Ultra-low interest rate regimes over the past 15 years boosted stocks markets reversed as central banks around the world, conducted by the US Fed tightening monetary policy seeks to suppress worker’s wage demands in the face of the highest inflation in four decades.
In a recent statement on the UK crisis, Wall Street Journal columnist James Mackintosh wrote that it had sent a shock wave through global markets. It provides a warning to governments everywhere of the dangers of the new economic era we are joining, said in Britain via a toxic mix of politics, inflation, and higher interest rates.
He stated that while superlatives were often used in market reporting the ructions in the UK were truly extraordinary.
The Tory government’s actions had such a big impact because of the more general background of soaring interest rates, high debt, dire communications, and the decline of the country’s institutional credibility with most of those conditions applying to a greater or lesser degree across the developed world.
The most apocalyptic risk is that Britain is just the first victim of higher [interest] rates, he wrote, noting that, as had often happened in the past, it was problems in an area regarded as safe, in this case, pension funds, that caused difficulties.
The Fed is basing its program on the belief that higher interest rates will be able to halt inflation takes place in the class war launched under Fed chair Paul Volcker in the 1980s.
But as Financial Times columnist John Plender commented, changes in financial structure since Volcker’s day point to threatening financial instability.
According to Plender, the chief role of the financial system is no longer to take deposits and make loans but to refinance the debt that sustains global growth, and the consumption complex system is increasingly dependent on shaky collateral.
