10 Oct 2022
The Blame Game has started. Who should be held responsible for the shambles of last week? Let’s look at the suspects.
The UK government is the obvious answer. An ill-prepared mini budget which looked more ideological than thought through. Russia, with its further attempts to push up the price of gas. And pension funds and asset managers for being too complacent about the level of long-term yields. I put myself in this camp. Although I have been warning about negative real yields for a long time, I did not envisage the moves we saw last week.
The Bank of England (BoE) has also been blamed and I think this is unfair. The BoE was placed in a very awkward position with a fiscal easing that was not accompanied by any Office for Budget Responsibility (OBR) commentary nor a published medium-term plan from the government on how to rein in UK debt. As we saw, the attempt to calm markets through a reiteration of the commitment to their inflation target counted for little. The BoE intervention on Wednesday to support the long end of the UK gilt market was necessary but the timing, coinciding with a bond syndication, was a clear indication of policy on the hoof. Where I make my criticism of the BoE is in its conduct of monetary policy in preceding years – basically keeping interest rates too low for too long and continuing with quantitative easing when it was blatantly obvious that it was neither required nor desirable.
Policy priorities haven’t helped
In the interest of fairness, I would say that the Bank was following the orthodox policies prescribed to all central bankers in the last 10 years and that the UK government was complicit in this approach. But this consensus has had real economic impacts. Money has been mis-priced which has fuelled house price inflation, and reinforced the British infatuation with housing as an investment rather than a place to live in. Perversely, the obsession of governments to support the housing market and the fear of recessions has led policy makers down a blind alley of low growth, intergenerational disparities and investment misallocations. The problem is that the alternatives involve more immediate pain and the electorate can be unforgiving.
So where are we now? The cancellation of the 45p tax cut was inevitable given the opposition to it both within the country and the Conservative Party. But it accounted for less than 10% of the announced tax cuts and a very small element of the overall fiscal package. In itself it will do little to settle the unease about the conduct of economic policy.
Yields swing wildly
The yields on 10-year UK gilt finished the week at 4.1% having approached a peak of 4.6% on Wednesday. The carnage was really felt in the index linked market where real yields shot through the roof. Ultra-long real yields rose to 2% on Wednesday before closing the week at -0.5%, following the BoE commitment to buy long-dated conventional bonds. It is difficult to exaggerate the sense of astonishment at these developments. To see a long-dated gilt double in price over the course of four hours is extraordinary.
Selling pressure was felt across a wide range of assets as pension funds looked to provide collateral against their derivative positions. Non-gilt sterling investment grade spreads widened 20bps with extremely poor liquidity and increased bid-offer spreads being evident through the week. There was no real sector theme to the selling, with selling focus clearly on raising liquidity above all else. High yield spreads also widened, by around 50bps, and it was clear through the week that events in the UK were having an impact on other markets. Government bond yields in the US, Germany, France and Italy ended the week higher, although significantly below the highs of Wednesday.
There is yield curve dislocation in UK bond markets now – with the BoE intervention leading to greater inversion at the long end. Despite pension fund selling, I see considerable value in gilts and credit but am cautious about longer dated yields which are being temporarily suppressed. The UK avoided technical recession in Q2 but the rise in mortgage rates and the hit to business and consumer confidence means that the recession has been postponed by three months.
To end on a different theme. As someone of small stature (163cm) I was intrigued to read a news article about a cosmetic procedure that is gaining adherents. It seems that taller people are more successful, having higher lifetime earnings and more powerful jobs. In consequence there is a trend in some countries for smaller people (mostly men) to have their legs broken and splints inserted to add a vital few centimetres to their height. It is crazy story but somehow appropriate for a crazy week.
The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice. This is a financial promotion and is not investment advice.