During the last week of September, gilt yields went berserk, for a lack of a better word. On both Friday, 23rd September and Monday, 26th September, the 10-year gilt yield rose by ~50bps. That was not the end of it. The 10-year gilt yield closed at just below 4.6% on Tuesday, 27th September. As you can see in Exhibit 1, we had not seen gilt yields at these levels for a decade. In fact, the last time gilt yields were higher than this was prior to the Global Financial Crisis.
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Long story short, the extreme move in gilt yields was the market’s response to the unexpected fiscal plans delivered in a mini budget on Friday 23rd September by new Chancellor of the Exchequer, Kwasi Kwarteng. The main announcements were in the form of surprisingly large tax cuts, as the new administration made it clear they are on a path to accelerate economic growth and believe tax cuts are the answer. The scale of fiscal stimulus seemed to fuel market expectations of more aggressive rate hikes from Bank of England (BoE) to combat inflation than initially anticipated.
The mini budget included measures to ease inflation like the energy price cap of £2,500 confirmed for two years. However, the majority of measures, some of which are listed below, will only fuel the inflationary pressures in the UK economy:
• Planned increase in corporation tax from 19% to 25% has been cancelled.
• Reversal of the increase in National Insurance contributions from November 2022.
• Planned reduction in the Annual Investment Allowance will be scrapped.
• Off-payroll reforms (IR35) were reversed.
• Basic rate of income tax was reduced from 20% to 19% from April 2023.
• Top rate of income tax of 45% would be removed from April 2023 (this particular part of the plan has since been scrapped).
• Stamp duty thresholds for property purchases have been increased substantially.
Just to give some context, the total cost of these measures was expected to reach £161.5 billion over this financial year and the next four years (6.6% of current nominal GDP). This was in addition to the near-term support for households and firms with regards to energy bills. Altogether, the Treasury’s estimates for the total cost of these new measures was £311 billion (12.8% of current nominal GDP), which reflected the biggest set of tax cuts since 1972.
The market went into freefall, and it was clear that something had to be done. The biggest worry came in the form of pension schemes. Pension funds can benefit from higher interest rates, as the present value of their future liabilities is reduced; i.e. higher interest rates (if not hedged) may move all the underfunded pension funds, and there are many of them in the UK, closer to being fully funded.
However, the speed of the rise in gilt yields caught them out. This is due to the liability-driven investment strategies that the majority of pension funds implement to hedge themselves against extreme moves in inflation and interest rates, and for which they need to provide collateral. With the majority of the collateral provided by gilts, the rise in yields meant that many pension funds could no longer provide adequate collateral, creating a vicious cycle of forced selling and falling prices.
Step in BoE. Their next meeting was scheduled for November (following the 0.5% rate rise at their meeting last Thursday, 22nd September), but it was clear that any intervention from them could not wait until then. Various pension schemes, and even some asset managers, went to the BoE to voice their concerns with what was happening in the market.
That’s why, on Wednesday, 28th September, the BoE held an emergency meeting and announced that it would immediately start a temporary programme of quantitative easing (long-dated government bond purchases) to stabilise the market. It said it would do so at a rate of up to £5bn a day for the next 13 weekdays. This comes at a time when the BoE was supposed to start its quantitative tightening programme, which, of course, has now been postponed by a month.
The BoE cited the recent “significant repricing” of UK government debt and went on to further state that “were dysfunction in this market to continue or worsen, there would be a material risk to UK financial stability.”
The short-term reaction
The response from the BoE was the reassurance that the market was hoping for and, in all honesty, needed. Its announcement sent yields on the 10-year gilt to fall back to 4.02% from just under 4.6%. This downward trend should continue to persist while the BoE maintains its purchasing programme.
It seems as though the same effect was seen in the sterling market (see Exhibit 2). Sterling was hit in the same way that gilts were at the end of last week, and this continued through the beginning of last week; however, Wednesday’s announcement didn’t immediately cool the recent slide in the value of the pound, with the currency falling 1.5% to $1.05 at midday.
Sterling did, however, end the day with gains, reaching $1.08, though this could very well be a result of profit taking activities from parties in short sterling positions. While this may have prevented sterling from reaching the record lows of $1.03 early last week, it does seem to be heading in that direction, particularly given the clear divergence of monetary and fiscal policy in the UK.
Another reaction to the aftermath of last week’s market turmoil was the government’s decision to U-turn on plans to scrap the top rate of income tax on Monday, 3rd October, just a day after Prime Minister Liz Truss insisted that the measure would go ahead. This announcement did help sterling, which rose to $1.12. Gilts also benefitted, with yields going below 4% on the day. While the U-turn clearly helped markets on the day, it is worth noting that this measure was just one small part of the overall fiscal programme announced in the mini budget. We therefore conclude that the reversal is unlikely to keep sterling and gilts stabilised for too long.
The longer-term worries?
It looks like the BoE were successful in their attempt to stabilise the gilt and currency market, but this is not the real measure of their success, which is issue number one. The second issue is sterling.
Issue number one – the BoE’s credibility. The emergency move last Wednesday, whilst necessary, increased concerns about the Bank’s independence, particularly given it is loosening and tightening monetary policy at the same time. From the outside, the perception is that the BoE is far too close to the UK government and the Treasury as things stand.
Even worse, these moves are clearly countering the BoE’s own ability to manage inflation, which is the only remit it should be concerned with. Its initial quantitative tightening plans are now muddled. And, who knows – 13 days of bond purchases may not be enough. It is not inconceivable that the BoE may have to extend this programme, especially if the concerns surrounding public debt do not go away, which will be the case if the Chancellor or the new administration do not recall or restrain its mini budget further.
Issue number two – sterling. While the BoE’s announcement did not provide as much initial support to sterling as they probably expected, it did recover most of its losses eventually.
However, sterling has been trending downwards for a while now, and this has largely been a result of the worsening deficit situation and the issues surrounding fiscal policy decisions. These issues have not gone away nor will they. It seems that, in the near future, the clear dispersion between fiscal and monetary policy in the UK will continue, and we believe that the value of the pound will largely depend on the aggressiveness of these policies. The BoE has underwhelmed markets on numerous occasions, with their last meeting being one of them, whereby the Bank rate was only hiked by 0.5% despite the market expecting 0.75%.
Going forward, the BoE will need to act more reassuringly and meet market expectations to keep the pound from slumping further (though higher rates do have many other market implications like rising defaults). If it cannot or does not do that, with the new fiscal policy programme in place, inflation expectations will rise, and sterling will be very vulnerable to a break of parity against the US dollar at some point this year.
04 October 2022