Just like the rest of the world, the United Kingdom is having a hard time bringing down inflation. With its July and August CPI reports at 10.1%, and 9.9% respectively, these are levels not seen in 40 years.
In its efforts to fight inflation, the Bank of England (BoE) has made seven consecutive rate hikes from 0.10% to 2.25%. Since the situation does not seem to get any better, the U.K. Government and the BoE have decided to use more fiscal and monetary tools to stabilize the economy.
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Government Takes Action
The U.K. government announced on Friday, September 23rd its “mini-budget” including a new tax cut package with the objective of tackling high energy costs and inflation, as well as delivering higher productivity and wages.
“Economic growth isn’t some academic term with no connection to the real world. It means more jobs, higher pay, and more money to fund public services, like schools and the NHS. This will not happen overnight but the tax cuts and reforms I’ve announced today – the biggest package in generations – send a clear signal that growth is our priority,” said Kwasi Kwarteng, Exchequer Chancellor.
The plan did not include any spending cuts to help pay for the government income reduction. This made investors and economists believe these economic measures could disproportionately benefit the wealthy and can force the U.K. to take on higher levels of debt at a time of rising interest rates.
The Bank of England Takes Action too
The BoE had plans to sell down its 838 billion pounds of government bond holdings, which had been due to begin next week, this is a monetary policy tool called “quantitative tightening” (QT). It is used to reduce the money supply and consequently bring down inflation.
“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,” the Bank of England said.
“In line with its financial stability objective, the Bank of England stands ready to restore market functioning and reduce any risks from contagion to credit conditions for UK households and businesses,” it continued.
On Wednesday, September 28th the BoE delayed the start of its QT program until October 31st and announced its new plan to purchase 65 billion pounds of long-term British bonds. Its objective is to claim the market chaos unleashed by the “mini-budget” announcement.
This last resource the BoE is using is called “quantitative easing” (QE). QE is generally used to increase the money supply and consequently increases inflation. The fact that the BoE took the decision surprised the market given this is precisely contrary to what the BoE is trying to achieve.
The Market
Sterling-USD
These events had consequent market effects, with the Sterling briefly falling 4% to an all-time low of $1.0382 against the U.S. dollar on September 26th. On September 7th the Market saw the Sterling pound plunged to its lowest point Since 1985 Versus USD, only to see it hit a new record lower at the end of the month as a consequence of the new economic policy.
“I think that [the] collapse in the sterling actually led to further risk aversion, generally risk-off sort of sentiment, intensifying further down,” said Saktiandi Supaat, FX strategist at Maybank.
GBP-USD Chart (February 23rd, 2022-October 7th, 2022)
Source: YahooFinance
30-Year Bond
The price of the 30-year “gilt” or British bond had the worst of it by falling more than 24% from the meeting on Thursday until Wednesday, September 28th. Then the BoE announced its QE program and the price rallied by 24% from its low in a matter of hours.
U.K. 30-Year Gilt Chart (Sept 20th, 2022-Sept 29th, 2022)
Source: MarketWatch TMBMKGB-30Y
FTSE 100
FTSE 100 hit its last high peak on September 12th raising over 7,400. Its recovery from a lower of 6,881 on September 29th to 7,086 on October 4th was paused by the reaction to Prime Minister Liz Truss’s discourse at the Conservative Party Discourse.
“I am ready to make hard choices. You can trust me to do what it takes. The status quo is not an option”, she said. “We gather at a vital time for the United Kingdom. These are stormy days …. We need to step up. I’m determined to get Britain moving, to get us through the tempest, and to put us on a stronger footing.”
FTSE 100 Chart: (October 7th, 2021 – October 7th, 2022)
Source: LondonStockExchange
What Could Explain the BoE Decision?
The pension funds were the eye of this hurricane since they entered into swap contracts placing gilts as collateral. As the gilt price plunged nearly 25% there were a massive number of margin calls forcing the pension funds to sell their gilts to meet these calls, sending their price even lower.
“There are schemes running out of cash at the moment,” one pensions consultant said before the BoE intervention. “This was a response to a fairly specific issue with the LDIs and the relationship they have with pension funds.“
The pension funds had to sell other sufficiently liquid assets, spreading the conflict to other financial products. The economy was facing imminent pension funds insolvencies.
Considering the potential economic consequences that this could bring, the BoE decided to use QE to boost gilt prices and avoid a major contagion.
The Aftermath
“The longer you stay in this la-la land of QE, floored interest rates, dislocated markets, funny interventions, distorting asset allocations … the harder the exit” – Mohammed El-Erian, CNBC “Squawk Box”.
The Central Bank’s efforts worldwide to improve their economy and the little success they have found, is forcing the market to lose trust and confidence in its own monetary authority.
The event that took place in the U.K. in September just gives another reason for traders to be more hesitant about where to put their money on. The last decision made by the BoE gives grounds to believe they are now using desperate measures to achieve something that looks very far away.
The fact that the pension funds are now seen as a systemic weak point is very concerning and gives the market a brief taste of the scope that this situation could have. It looks like uncertainty will stay here for a while and traders have another thing on top of their minds.
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Author: Emiliano Gama
Intern
email: egama@tvmarkets.com
