Today (28/09/2022) we saw a remarkable intervention by the Bank of England into gilt markets in reaction to the government’s mini-budget last week. When financial news moves from the finance pages to the front pages, it usually does so with a large amount of fear and misreporting about what is really happening. Today is no different.

On Thursday last week, the new Chancellor, Kwasi Kwarteng, released the UK government’s plan to try and improve growth of the UK economy. I’m sure you’ve seen the reports but to recap the main headlines were.

• Top rate tax of 45% removed
• Basic rate of income tax cut to 19% (from 20%)
• Corporation tax rise cancelled, leaving rate at 19%
• Stamp Duty Land Tax minimum raised from £125,000 to £250,000
• Limit into SEIS doubled to £200,000 per year
• VCTs and EIS to continue
• IR35 reform scrapped

Politically, this was an interesting budget to say the least. Offering major tax cuts to the wealthiest earners makes a real statement as to the type of government they want to be. I’ll just leave it there for the politics.

The greater interest was in the market reaction and what we’ve seen so far has been fascinating.

Press goes into hyperbole over sterling selling off

In terms of market reactions, the biggest headlines of that and the following days were reserved for the value of the GBP in US$ terms. This is an example from the BBC website:

The most quoted GBP figure is always in US$ (or “Cable” as it is known in the markets, named after the first transatlantic cable that ran between New York and London, sharing information and data between the two financial capitals of the world).

The biggest problem with looking at the reaction of GBP in solely US$ terms is that the US$ has been considerably strong all year. The chart below shows the value of the US$ versus a basket of different currencies – not just GBP, but the Euro, Japanese Yen, Aussie Dollar etc.

This has been a huge move this year. Remember global commodities like oil, gas, copper, wheat, etc are all priced in US$ – hence a big contributor to inflation for most countries in 2022.

Looking specifically at the above chart though, note the big jump two days ago – that was the 26 September which was Monday – which was when the GBP headlines hit the newswires. A strong USD was a double whammy (my technical term) for a weak GBP and made the move look even worse on the day.

Perhaps more fair would be to compare the performance of GBP to Euros – as they are our biggest trading partner after all. Chart below.

You can see that still it was a large move, but the overall level is not that significant. Purposefully, this is a longer-dated chart as I wanted to highlight that in GBP vs Euro terms, we are only back to where we were at the start of 2021 as we’ve just broken below the steady 1.15 level it has been at for most of 2022. Also the most recent spike down to 1.08 was very early Monday morning (26 September), before even most Asian markets had opened for the trading day. This time of day is notorious for large moves on low volumes and the potential for market manipulation is high. Without any evidence, my guess is that is what happened as GBP steadied back above 1.10 as soon as the larger markets opened.

Government bond market was where the real story was taking place

So, a notable move, and certainly the speed has been spectacular, but the level itself is not especially newsworthy. That doesn’t stop the news from using highly emotive words like ‘crash’, ‘tumble’, ‘collapse’, etc just to raise the adrenaline levels and give everyone a good scare. Hey, it’s the press – what else do we expect?

But, before you think I’m saying this is a nothing story, let me show you where the real action has been: the UK government bond market, or gilts as they’re known. The press has actually been correct to highlight the concern in the markets, they have just focused their attention on the wrong place.

Let me explain.

The chart below shows the yield (or interest rate) on 30-year UK government bonds.

When looking at the most recent two days of trading on the chart above, the yields have moved by 1% each day. To put it bluntly, that doesn’t normally happen to bond markets in developed countries – perhaps places like Turkey, Thailand and Argentina get these moves – but historically it has not happened in the UK or anywhere else which has developed, liquid markets.

This is where the real issues have been raised and prompted the remarkable intervention by the Bank of England into the markets today.

So why did yields rise so much and so quickly?

The yield on a gilt is driven by investor demand and is a reflection on the perceived credit worthiness of the bond itself, which is therefore a reflection on the government which issues it.

The recent mini-budget and perceived increased risk to the UK financial position, plus the lack of scrutiny and clarity on costing, has raised the concerns of global investors and those who buy gilts. This raised concern has meant these investors need higher interest rates to purchase bonds as they want to be paid more interest for the perceived greater risk of owning UK government debt.

This hopefully explains the reaction to the mini-budget that we’ve seen over the past few days in the bond markets. Yields have risen aggressively which means the market value of gilts fell. Remember with bonds, as yields rise (which the chart shows), the value of the bonds fall.

Such aggressive, sharp moves in financial markets inevitably cause casualties (the slightly bizarre analogy is of underwater explosions and fish slowly rising to the surface) and this is what happened this morning.

Earlier today it was reported that some defined benefit pension funds – so those funds that offer, for example, final salary pensions – were facing significant financial pressures due to the falling value of UK government bonds such as the 30-year shown above. Without going into too much detail, it put them at serious financial risk of breaking their regulatory collateral limits on their assets. This was reflected into the Bank of England Financial Policy Committee (FPC) which is a different arm than the more well-known Monetary Policy Committee (MPC) that sets interest rates. The FPC is more concerned with market stability and it was the FPC’s decision today to step into the market and buy an unlimited amount of 30-year gilts for the next two weeks to stabilise the market.

This is what caused the sharp 1% fall in yields reflected in the chart above today as the price of these gilts was supported by the Bank of England decision and rose.

The Bank of England news release on justifying its decision is fascinating:

This repricing has become more significant in the past day – and it is particularly affecting long-dated UK government debt. Were dysfunction in this market to continue or worsen, there would be a material risk to UK financial stability. This would lead to an unwarranted tightening of financing conditions and a reduction of the flow of credit to the real economy.

To say this is extraordinary is an understatement.

So what now?

The stabilising factor has worked for now and importantly it has not rolled over into issues with equities or other credit markets. Let’s see what happens in two weeks when the buying stops, but time is the ultimate luxury in financial markets as it allows the dust or panic to settle and clearer thinking to prevail. That is both the Bank of England and UK government’s hope at the moment. And as we know, a lot can happen in two weeks in financial markets – and politics.

From an international perspective, the biggest problem is the continued strong US$. The US$ remains strong on the expectations of continued interest rate rises by the US Federal Reserve to combat inflation. US interest rates are currently just over 3% and expected to get to 4.5% and pause, so there are more rises coming. In market turmoil times, there is also a tendency to rush to the two most defensive currencies in the world – the US$ and the Swiss Franc (CHF) – so that is also playing a part.

To start with the negative, clearly if there are further systemic risks in the financial system these should appear in the next few days. With luck, they can be contained. Market regulators and governments will hopefully heed the lessons of 2008 and understand that risk that becomes systemic is the worst possible outcome. Let’s wait and see.

A positive scenario would be either if the US starts to show slightly weaker inflation figures and/ or the Federal Reserve realises that raising interest rates so quickly can have significant unexpected ramifications, an example being today. Input prices are falling with lower demand globally so there is some evidence this is happening already but not through in the inflation data yet. Time will tell.

Importantly, markets remain liquid and there is no sign of real panic in equity markets. As always, I advise to stay the course and stick to your plan. As ever, I remain very watchful.

I’ll leave you with a well-known market expression: “Central banks raise interest rates until something breaks”. Today we saw something nearly break. Let’s see if that causes thinking to change.

Stay well,

Adam

P.S. As I’m pressing send, I see the BBC has updated their website – image below. Maybe I owe the press an apology after all?