Chaos Will Return To UK Assets

Admittedly, it feels gratuitous to dwell on the most chaotic week for UK markets since Brexit.

At the same time, though, the proximate cause of the volatility (the uncomfortable juxtaposition between determined monetary tightening and fiscal largesse centered on discredited supply-side gimmickry) isn’t going away. So, neither is the volatility.

Perusing finance-focused social media, it’s obvious to me that most market participants don’t fully grasp what’s so problematic, of if they do, they don’t want to admit it because their affinity for counter-narrative demands they defend whatever the out-of-consensus view is, irrespective of whether it makes any sense.

Liz Truss isn’t just pursuing unfunded fiscal stimulus. She’s pursuing unfunded trickle-down economics, and no, that’s not just some “liberal talking point.” We have a tendency post-2015/2016 to castigate every point of contention between right-leaning, populist libertarians and everyone else as a “liberal” (or “socialist” or “progressive”) talking point. In many cases, that’s a canard. In the case of Truss’s growth plan, it makes no sense whatsoever.

Believe it or not, this isn’t about politics. History has shown that these sorts of tax cuts simply don’t produce the kind of economic miracles proponents preemptively claim for them. That’s not necessarily to say they don’t work at all, depending on your definition or “work,” but it is to say they don’t deliver as advertised. Besides that, they almost invariably have to be rolled back.

More importantly, the UK issues a reserve currency, but not the reserve currency. That’s a critical distinction. The pound isn’t the Turkish lira. Truss’s latitude is (very) wide. But the pound isn’t the US dollar. Which means Truss’s latitude isn’t unlimited.

As maddening as this might be for the rest of the G-10, unless you’re the US, there’s a threshold beyond which markets won’t countenance the appearance of profligacy. To be fair, nobody knows where that line is for reserve-currency issuers. And wherever it is, it’s not fixed. It moves depending on the circumstances. While it’s totally unrealistic to suggest Truss should’ve known that her plan would trigger a crisis, it’s entirely fair to say she should’ve known it was likely to cause consternation, especially at a time when the Bank of England had committed to trimming the size of its balance sheet by actively selling large amounts of government bonds.

Do note: That’s not a difficult ask. She was aware of the BoE’s imminent QT program, but if she cared it wasn’t obvious. That’s a problem in and of itself. In fact, that may well have been one of the biggest problems: The appearance of aloofness. Kwasi Kwarteng’s ill-advised “The markets will react as they will” remark made things immeasurably worse. He effectively dared the bond vigilantes to shoot at gilts less than 24 hours after the central bank confirmed plans to withdraw its support for government bonds. That suggests an almost inconceivable level of arrogance which markets (and at least one Tory lawmaker) understandably interpreted as “inept madness.”

By the end of the week, UK bonds retraced some of the selloff, and sterling more (figure below), but just as it’s impossible to know how much of the rout in gilts and the pound was due to forced selling and panic, it’s difficult to know how much of the rebound was attributable to traders repositioning following the BoE’s intervention and otherwise unwinding some of the overshoot from gilts’ existential collapse and sterling’s plunge to a record low.

Although it’s not obvious on a quick glance, the moves illustrated in that visual are very large. Yields leapt from under 3% to 4.5% then retreated back down to 4%. In sterling, it looked briefly like parity was imminent.

Whatever you want to say (good, bad or otherwise) about Truss’s plan or even about Truss herself, I can assure you that those on social media insisting the market “got it wrong,” aren’t actually involved in markets in any meaningful way. The entire UK pension complex nearly imploded. It’s so bad that funds are asking clients for money.

“British pension funds with big losses in gilt market derivatives have sought emergency funds from the companies they manage money for as they race to dump assets to raise cash,” Reuters reported on Friday afternoon, citing industry sources. Effectively, they need to put their hedges back on. “Some pension funds sought help from their sponsors, the parent entities whose employees’ pensions they manage, including trying to open credit lines with banks,” the same linked article noted.

Make no mistake, this isn’t a drill. It’s not a joke, either. It’s not some political debate that can be carried on, civilly or not, in a vacuum. Outflows from UK-focused equity funds are on track for their worst year ever (figure on the right, below).

Weekly outflows are a history of bloodletting (figure on the left).

The LDI story surely isn’t finished, and the BoE will likely find itself in a horrible bind going forward. If they do indeed intend to sell the long-dated bonds they committed to buying to calm markets this week, and if they also intend to commence their previously announced QT program in a few weeks, that’s going to leave gilts trading without a net. Again. If Truss doesn’t repent, the market may well start shooting at UK bonds. Again. And if the BoE steps in, the attendant money printing (financing intervention with new reserves) will undermine the currency. Again. Then we’ll be right back where we were in the immediate aftermath of Kwarteng’s mini-budget.

Truss has given no indication she’s prepared to abandon her policies. “I recognize there’s been disruption but it was really, really important we were able to get help to families as soon as possible,” she told the media Friday. In an Op-Ed for the Telegraph, Kwarteng echoed her sentiments: “We had to do something different. We had no other choice.”

Regulators are nervous. “The UK watchdogs responsible for the £1.5 trillion corner of the pensions sector that came close to imploding this week are holding daily talks with asset managers to stave off a fresh crisis when the Bank of England’s emergency bond buying ends,” the FT reported. Officials, the linked article said, “have called emergency meetings” out of concern for the possibility that “when the BoE withdraws its support, the bond selloff will resume, causing yields to rise and putting more pressure on defined-benefit pension funds, which dumped gilts as they sought emergency collateral.”

My guess is, the BoE will have to postpone QT indefinitely, and that they in fact won’t be able to sell any bonds bought as part of the emergency intervention. If that turns out to be true, then the “temporary,” “time limited” purchases (as the bank called them) will be remembered as the re-establishment of QE. The fact that the bank intervened to preserve market functioning, not bring down yields to stimulate the economy, is a difference without a distinction. Long-end yields were lower as a result of the BoE’s actions irrespective of their rationale. All else equal, lower yields represents an easing of financial conditions. And conjuring reserves is inflationary. And perpetuating a circular funding scheme when you’re not the Fed can cause a run on your currency absent an improvement in the underlying fundamentals. The UK’s fundamentals aren’t improving. They’re getting worse. It’s just that simple.

Bottom line: There’s no way to talk around this. Truss is in trouble, so is the BoE and so, therefore, are UK bonds and sterling. Spin it any way you like, but I can assure you traders and investors won’t listen. As Kwarteng so aptly put it, “markets will react as they will.”