UK turmoil
On September 6th Liz Truss took over as Prime Minister of the United Kingdom replacing Boris Johnson, whose reputation had really faltered during his handling of COVID-19.
On September 23th, the Treasury Secretary (the equivalent of the chancellor of the exchequer Kwasi Kwarteng) announced plans for a budget to be voted on in November. Bearing in mind this budget, he claimed that the way out of the depressive economy we are facing was simply to reduce taxes, more specifically, to reduce taxes of the rich social class by cutting the top tax rate from 45% to 40%. Moreover, instead of raising the corporate tax rate from 19% to 25%, he proposed to get rid of that hike as well as cutting stamp duties to buy real estate and to offer stimulus for energy bills to businesses and homeowners. These Truss’s moves were going to be taken into account in November.
That night Kwasi Kwarteng allegedly went out partying with hedge funds who likely stand to benefit from the now lower top tier taxes.
On Monday the market fell. It appeared that the United Kingdom was about to spend more money and reduce tax revenues during an inflationary time, stimulating the economy while reducing revenue for the government and requiring more money printing, which again leads to higher inflation. All this while interest rates should have been going up to lower inflation, especially when the inflation rate was just down from a high all the way down to 9.9%.
Over the week after the British Pound collapsed to a new low of $1.03. It recovered to $1.12 but not before causing massive stress in the bond market which undeniably exposed them. Basically, their equivalent of the 30-year treasury bond known as “gilts” lost 20% of their value extremely quickly. Being a buyer or a holder this isn't a big deal, you just hope one day it recovers. The problem regards pension funds, which instead are loan-buyers and holders.
In England in fact, there's an entire pension fund system, known as LDI Asset Management, which stands for Liability Driven Investment management. This is the reason why Jamie Dimon (American billionaire businessman) commented: “I was surprised to see how much leverage there was in some of these pension plans”.
Pension funds are basically retirement plans, which guarantee a pension in a sum of years. In order to provide money in the future, they need to make investments today. Because interest rates were very low for over a decade, pension funds felt the need to borrow a higher quantity of money in order to do their job. Due to the fact that the interest rates were so low, the government decided to just borrow money to increase their returns. This way works well when the market’s going up, but it shortly becomes a problem when all of a sudden bonds drop 20%. This quickly led to a spiral of panic as pension funds started to get margin calls on debt due to the rapidly plummeting value of their assets.
This whole situation led pension funds to sell more bonds, depressing value even further. As a matter of fact, they're about 1 and a half trillion Great British pounds worth of LDI investments in the system. Custody banks that dealt with these pension funds:
had so many margin calls with which they were dealing with, they didn't even have enough staff to help process how many margin calls were coming in;
hadn't enough liquidity, meaning that the pension funds didn't have enough cash, so they had to dump the motion to be able to move money.
The turmoil provoked by Liz Truss’ plan led to a desperate need of a decisive intervention by the Bank of England.
Reaction of bank of England
On Wednesday, September 28th, the Bank of England took emergency action to stabilize U.K. financial markets and to head off a crisis in the broader economy, followed by a chain reaction through the market. This very specific intervention took place to prevent a “doom loop” of forced selling of UK government bonds by pension funds, which operate Liability Driven Investment (LDI), in need of liquidity and to help to buy time to unwind their derivatives positions.
The central bank promised to buy long-term government bonds (in particular 10 to 20 year gilts) until mid October, for an investment of £65bn – £5bn a day. British 30-year bond yields had hit their highest since 2002 on September 28th, pushing up government borrowing costs and worrying CB. Left unchecked, collapsing gilt prices could have caused a domino effect of fire sales of assets, pushing prices yet lower and creating more forced sellers.
UK 30Y Treasury Gilt yield - Trading economics
The measure of CB consisted in entering the market buying bonds, in order to increase the number of purchasers and so pushing up their value. A higher value tells other potential buyers that the bonds are less risky to purchase, bringing down the interest rate. The measure was billed as temporary and targeted, but has already brought down the cost of borrowing for the UK government. Interest rates on government debt fell on Wednesday after the Bank intervened, with the 30-year bond rate moving from above 5% to below 4%.
On October 10th, the bank announced additional measures to support an orderly end of its purchase scheme (fixed on 14th October).
First, the Bank claimed to stand ready to increase the size of its daily auctions to ensure sufficient capacity for gilt purchases ahead of 14th October. Second, it promised to launch a Temporary Expanded Collateral Repo Facility (TECRF), which will enable banks to help to ease liquidity pressures facing their client LDI funds through liquidity insurance operations. Under these operations, the Bank will accept a wider range of collateral than normally eligible under the Sterling Monetary Framework (SMF). Third, BoE affirmed to be prepared also through its regular Indexed Long Term Repo operations each Tuesday to support further easing of liquidity pressures facing LDI funds. This permanent facility will provide additional liquidity to banks against SMF eligible collateral and so support their lending to LDI counterparties. Liquidity is also available through the Bank’s new permanent Short Term Repo facility, launched last week, which offers an unlimited quantity of reserves at Bank Rate each Thursday.
On October 11th CB said it will widen its purchases of U.K. government bonds (gilts) to include index-linked gilts from October 11th until October 14th. Index-linked gilts are bonds where payouts to bondholders are benchmarked in line with the U.K. retail price index. The move marks the second expansion of the Bank’s extraordinary rescue package.
As previously mentioned, the Bank terminated these operations and ceased all bond purchases on 14th October. In line with its financial stability objective, these operations have enabled a significant growth in the resilience of the sector.
The effectiveness of BoE impact and its ability to still be capable of reassuring the market had not been taken for granted by investors, allowing them to breathe a sigh of relief. Crucial point is that the Central Bank does not intervene unless there is a serious risk of deep financial trouble: defining it a ‘dysfunction in the market’ capable of harming the financial stability of the country, CB highlighted the impact that it could have had. Last time it intervened was due to the pandemic and before due to the financial crisis-even if these measures lasted longer. Being it a response to a government measure (‘mini-budget’), it underlines how harmful can be a fiscal policy not aligned with a monetary one.
Despite all these measures, investors are being dragged into a scenario of uncertainty. The UK government replied with perhaps the biggest U-turn in British economic history, leading to a stabilization of the market but mostly revealing the unreliability of Truss’s measures.
UK tax U-Turn
The U.K. government backtracked on a key part of its broad tax-cut plan after facing a backlash from financial markets and a rebellion in its own ranks, marking a major setback for the new Prime Minister Liz Truss and her economic agenda.
U.K. former Chancellor of the Exchequer Kwasi Kwarteng shelved an initiative to cut the top rate of income tax from 45% to 40%, more than a week after a broader fiscal plan to stoke growth through tax cuts and new spending forced an emergency intervention by the Bank of England to prevent a financial crisis. The move to slash the top income-tax rate was a small part of a much bigger stimulus announced on Sept. 23 that paired large subsidies to help homeowners and businesses cope with rising energy costs along with the biggest tax cuts in a generation, a package funded by borrowing that raised alarm among investors.
Despite the change, questions remain about the plan’s economic viability. The change will affect only £2 billion, out of an initial package of tax cuts that totalled £45 billion in foregone revenue for the government, according to the Institute for Fiscal Studies, an independent think tank. It estimated that the British government would still require an additional £72.4 billion in debt issuance this year. This is “a rounding error in the context of the public finances,” said Paul Johnson, director of the IFS. “The chancellor still has a lot of work to do if he is to display a credible commitment to fiscal sustainability.”
Political analysts said the Truss government was likely bowing to political reality as much as economic reality: “This move is rather symbolic, being less about the amount of money it will save and more about the poor signal it had delivered of ideological tax cuts,” said Chris Turner, an analyst at ING Bank. “The move looks driven by a backlash from her own party and perhaps the threat of a sovereign rating downgrade.”
On the 14th of October, Kwasi Kwarteng was fired, and Jeremy Hunt took his place. The new U.K. Treasury Chief Jeremy Hunt reversed nearly all the government’s proposed tax cuts and will scale back an energy price-cap subsidy as he moves to reassure markets about the stability of the nation’s finances.
Together with other steps announced over the weekend, the new moves represent a near total U-turn on the package of measures that Ms. Truss’s government announced last month: out of a total of £45 billion of tax cuts announced by Ms. Truss's government on September the 23th, only remained about £12 billions. A planned cut in payroll tax and a reduction in a levy on property purchases, according to the Institute of Fiscal Studies. Furthermore, Mr. Hunt said that an income-tax cut planned for next year would be shelved indefinitely and that other proposed tax cuts would also be axed, including freezing duty on alcohol and a levy on dividends.
While it is good that Mr. Kwarteng’s ill-conceived tax cuts have been canceled, U.K. policy is now more aimless than ever, trapped between another potential leadership battle and the prospect of a straitjacketed government until as late as January 2025, the deadline for a parliamentary election. Mr. Hunt seems to be focused on reducing bond yields over the next two weeks so that they are a bit less scary when the U.K.’s independent fiscal watchdog publishes its medium-term projections for public debt. At current levels, a flat debt-to-output ratio in three years would demand £40 billion more in annual savings, according to Samuel Tombs at Pantheon Macroeconomics.
Six weeks into the job, Truss has been buffeted by a bond market rout, suffered the lowest approval ratings of a British leader in decades, abandoned almost all of her policy programme and has now lost her interior minister who quit less than a week after she fired her finance minister. Conservative peer Lord Ed Vaizey has echoed calls for Liz Truss to step down, adding that six Tory MPs could be vying to replace her. On October 20th, Liz Truss resigned as prime minister after 44 days in office marked by turmoil, triggering the second Tory leadership election in four months leading to Rishi Sunak being elected.
This event marks a crucial point in British history, with Truss expected to be the shortest-serving prime minister. Despite the stabilization of the situation with her resignation, the UK remains a scenario where to look for new developments, in order to prevent possible major crises.
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