Britain has long had a reputation for having a sound currency. But following Kwasi Kwarteng’s mini-budget, the markets ruthlessly swept away that reputation.
Historically, the safest place to invest in advanced countries has been government bonds. In the case of the UK, these bonds are known as gold stocks because they have always been considered as good as gold and the original certificates of ownership had gold edges.
Since time immemorial, they have been issued to investors by governments to fund their borrowing needs.
During the two major catastrophes of recent times – the Great Financial Crisis of 2007-09 and Covid-19 – the gilt market has remained largely impervious to events despite government debt levels reaching some £2 trillion, essentially the value of production for the whole UK economy.
Chancellor of the Exchequer, Kwasi Kwarteng, seen arriving at the back of Downing Street this morning. Since Mr Kwarteng’s mini budget, the markets have ruthlessly swept away Britain’s reputation for sound money
The pound plunged again in value this evening after the Governor of the Bank of England announced that support for the bond market would be withdrawn on Friday
Much of this was due to careful management of public finances by successive Conservative administrations who ensured that the debt did not rise even further. Indeed, other advanced countries have allowed their debt levels to climb well beyond 100% of output.
All that good work, however, has now fallen apart.
It’s not just that the International Monetary Fund this week reiterated its doubts about Britain’s economic outlook. Or that the Institute for Fiscal Studies has warned that the government faces a £62billion black hole in its financial plans.
Chaos now reigns in financial markets as price movements in gold stocks – normally a calm but stabilizing backwater of the financial system – have been unprecedented in their magnitude.
This may seem like a mysterious question far removed from our daily lives. But the truth is that the stock of gilt and the health of the gilt market is an indicator for the economy.
When investors lose faith in gilts, it’s a sure sign that they’re losing faith in Britain’s financial stability. And that means trouble for all of us, most immediately in the form of higher interest rates and mortgage payments, but also potentially catastrophic problems for pensions.
Bank of England Governor Andrew Bailey (pictured) said the bank would not extend support beyond the end of the week, sending the pound plummeting immediately
The Bank of England’s intervention in the gilt market in recent days – offering to buy up to £65bn of gold stocks to preserve financial stability – is a measure of our concern.
Nothing like this has been seen since Britain was ejected in 1992 from the exchange rate mechanism (ERM), the precursor to the euro zone which linked the value of the pound to that of the German mark.
At the time, the Bank was proposing to raise interest to an astronomical 15pc in an effort to support sterling and the gilt market, before it was admitted that the link to the mark was unsustainable and that we were leaving the ERM.
This time around, the Bank’s initial intervention a fortnight ago was to stabilize a crisis in what are called long-term gilts — government bonds that mature in 30 years. It seemed to work. The market recovered, for a while.
But now the Bank has had to step in again, after the contagion spread to another area of the gilt market – index-linked bonds, where yields are tied to the rate of inflation. This is an unpleasant sign of investor concern.
As I said, UK gilts have long been considered the safest investments. They are a repayment guarantee – in effect an IOU – from the government of a first world country that has never defaulted. They have always been considered inviolable.
Daily Mail City editor Alex Brummer writes that UK gilts have long been seen as safe investments
Indeed, the response of the Bank of England and other regulators after the 2007-09 banking crisis – when defaults occurred on all sorts of debt – was to require banks, insurance and pension funds that they increased their holdings of gilts because they were so safe.
The move was intended to protect pension holders from the extreme volatility affecting the markets for stocks, real estate and other more exotic assets such as private equity and hedge funds.
But if gilts were such solid investments, why did the market turn around?
The presentation of the £45 billion in unfunded tax cuts from Liz Truss and Kwarteng and the failure to have them properly audited by the Office for Budget Responsibility led to chaos. This caused the value of long-term gilts to plummet, and institutions that held gilts, such as pension funds, began to sell.
All of this was fueled by the fact that, in the search for better returns for defined benefit pension plans – which support the lifetime savings of some ten million people – financial institutions had taken new risks. They decided to make the working people work more, believing that this would help eliminate the shortcomings of many plans.
As a member of the “investment committee” of a private sector fund, I recall several presentations by external pension fund advisers to trustees encouraging them to use complex debt instruments, known as derivatives, to try to improve returns.
As far as I and at least one other fiduciary were concerned, if it was impossible to understand the complexity of the financial instrument, it was better to stay away.
But that didn’t stop the industry from using these derivatives – or liability-driven investing (LDI) – to sweat pension plans by increasing leverage levels relative to the gilts they held. .
Today, the city has over £1 trillion of ILDs working to improve returns on defined benefit schemes.
But as was the case during the financial crisis, the rush to higher yields proved extraordinarily toxic.
City businesses such as Blackstone, Legal & General, and Schroders encouraged more and more borrowing against gilts, and the money thus raised was plowed back into more and more government stock.
It was fine under normal business conditions. But the mini-budget caused markets to turn to the pound and embark on a sell-off in long-term government securities which fell in value sharply, prompting interest rate hikes.
The Bank of England injected £65bn into the gilt stock market following Kwasi Kwarteng’s mini-budget
Regulators stress-tested LDIs for a full one percentage point change in gilt interest rates. But the rate change quickly reached 1.6 points, triggering a cascade of selling as leverage or borrowings had to be repaid. This threatened insolvency for lenders and earthquakes for pension funds. And the Bank of England had to intervene.
Its support operation is due to end on Friday – which is one of the reasons for renewed market jitters over gilts – but the Pensions And Lifetime Savings Association is now calling for the support to be extended.
Today Bank of England Governor Andrew Bailey said the bank would not extend support beyond the end of the week, sending the pound down immediately as stricken pension funds were rushing to raise hundreds of millions of pounds.
With the problem extending to indexed bonds – the most sensitive area of the gilt market – pension funds feel dangerously exposed, as they own 72% of indexed gilt issues.
The drama caught the attention of the whole world. At the International Monetary Fund’s annual meeting, which I attend in Washington, the Fund’s chief regulator, Tobias Adrian, said Britain was paying the price for having two people at the wheel, “each trying to steer the car in a different direction”. .
In other words, the Bank of England’s policy of tightening interest rates as fiscal policy eased with Kwarteng’s tax cuts was a mistake.
Either way, the fact is that gilts – once the gold standard of investing in this country – have faded. And that is deeply worrying for Britain.
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