Pounds & Gilts

Most global currencies have been declining against the US dollar, or looked at the other way around, the USD has been appreciating against most other global currencies. In light of the gains of the US dollar against virtually every other asset – bonds, stocks, gold, copper, and more recently even oil and gas – we could quibble that it’s much more of the latter than the former. But some of those other currencies have been notable losers. Due to the Bank of Japan’s insane attachment to negative yields across the Japanese government bond market, the Japanese yen has the poster child for abandoned currencies. Until last Friday that is … at which point the British pound stole this dubious spotlight.

I make no claim to expertise in currencies and bonds outside the United States, but this is what’s moving markets now and we don’t have the luxury of ignoring things just because they’re outside of our comfort zone. The same fundamental principles apply to currencies as any other securities though, so we won’t claim complete ignorance either.

Last week the incoming Prime Minister shocked the markets by announcing what amounts to a great expansion of UK debt, combining tax cuts and subsidies for energy bills. The notion of fighting energy price inflation by injecting more money into the demand side boggles the imagination. Of course the pounds required to pay for all this have to come from somewhere, and without any other obvious candidates the markets suspect that somewhere will be nowhere. The result was a plunge in the value of the British pound.

Today the Bank of England poured fuel on the fire by saying it will study the situation and consider responding at its next regularly scheduled policy meeting. Markets apparently having hoped for something more concrete again trashed the pound.

How this will improve the power of UK households to purchase energy or anything else isn’t clear.

These developments however affect investors everywhere, not just in the affected countries. Japan for instance has been dumping US Treasuries to fund a quixotic quest to buck up the yen to defend it from the actions of its own central bank. Since Treasuries serve as the benchmark to establish yields and consequently prices of virtually all the world’s assets, the only possible place investors could hide would be another planet. For the time being however, an ample allocation to US dollars and short term US Treasuries has been the preferred refuge.

While reader comments are always welcome, those from UK readers familiar with these developments and their context are especially so.

31 thoughts on “Pounds & Gilts

  1. sunpearl71 says:

    My two cents (or pence, which based on current trends could both be equal very soon!), as a UK-based reader of Financology.

    The main action of the government that has led to the recent fall in the pound’s value is the reduction of tax rates disproportionately to the higher earners with the rationale of promoting growth.

    This is being viewed and commented on using the following perspectives:
    Economic – applying the higher % of reduction to the top rate tax payers is not going to generate the levels of growth needed (trickle down economics has been shown to be ineffective).
    Social – promoting inequality by reducing the % of tax for higher rate payers more (5%) than those in the lower bands (1%).
    Political – ignoring the current socio-economic situation and implementing their dogmatic policy of lower taxes and regulation will lead to higher growth. This approach may have worked earlier in the economic cycle, say pre-Covid but not in the current geo-political climate.

    At the middle of it all is a government that has lost its credibility with the markets causing the pound to tank. As for next steps, things are likely to be rolled back as something has to give in terms of the tax changes or the support to deal with higher energy prices.

    The context here has been a steady erosion of UK productivity post-GFC and the austerity imposed by successive Conservative governments have left the UK economy weak to deal with significant macro developments such as the Ukraine war and the strengthening US dollar.

    This is an evolving situation and the latest news is that the Chancellor may be providing specific budgetary numbers with costings for the tax cuts and future spending cuts, thereby restoring at least some of the lost credibility.

  2. Llanlad2 says:

    My feeling is the government has caused the right thing to happen….by accident! The idea of cutting taxes and increasing public debt massively makes no sense to me. Predictably interest rates have gone up dramatically… and will probably override the illconceived benefits of tax cuts in terms of the amount of money in the economy… Leading to a tightening… Which is opposite to the intended consequence. I expect UK real asset prices and real estate to decline here .
    Bill’s excellent piece on the fact that prices are measured in a currency that is forever changing in value makes the outcome very difficult to predict though.
    As for the energy subsidies… People will cut their cloth accordingly regardless. People will wear jumpers instead of walking round in t-shirts. Or sit with blankets. Ie they will live like people lived before central heating. Bills have been promised to stay below £2500 a year. I hardly know a person that paid £1500 a year in the first place so a reduction in disposable income is still inevitable and the £2500 limit an irrelevance

  3. Bill Terrell says:

    Thank you Mega, Sunpearl and Llanlad for your insights … they are much appreciated.

  4. Mega says:

    Ah………..i didn’t know the £ was a reserve currnacy

    Bank of England intervenes in bond market
    The Bank of England says it will intervene in bond markets to try and stabilise them, after the recent selloff. Here’s the full statement:

    As the Governor said in his statement on Monday, the Bank is monitoring developments in financial markets very closely in light of the significant repricing of UK and global financial assets. This repricing has become more significant in the past day – and it is particularly affecting long-dated UK government debt. 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. 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.

    To achieve this, the Bank will carry out temporary purchases of long-dated UK government bonds from 28 September. The purpose of these purchases will be to restore orderly market conditions. The purchases will be carried out on whatever scale is necessary to effect this outcome. The operation will be fully indemnified by HM Treasury.

    On 28 September, the Bank of England’s Financial Policy Committee noted the risks to UK financial stability from dysfunction in the gilt market. It recommended that action be taken, and welcomed the Bank’s plans for temporary and targeted purchases in the gilt market on financial stability grounds at an urgent pace. These purchases will be strictly time limited. They are intended to tackle a specific problem in the long-dated government bond market.

    Auctions will take place from today until 14 October. The purchases will be unwound in a smooth and orderly fashion once risks to market functioning are judged to have subsided. The Monetary Policy Committee has been informed of these temporary and targeted financial stability operations.

    This is in line with the Concordat governing the MPC’s engagement with the Bank’s Executive regarding balance sheet operations. As set out in the Governor’s statement on Monday, the MPC will make a full assessment of recent macroeconomic developments at its next scheduled meeting and act accordingly. The MPC will not hesitate to change interest rates by as much as needed to return inflation to the 2% target sustainably in the medium term, in line with its remit.

    The MPC’s annual target of an £80bn stock reduction is unaffected and unchanged. In light of current market conditions, the Bank’s Executive has postponed the beginning of gilt sale operations that were due to commence next week. The first gilt sale operations will take place on 31 October and proceed thereafter. The Bank will shortly publish a market notice outlining operational details.

  5. Mega says:

    OK, its just after 1:00 pm GMT………….All Hell is breaking loose
    The Government is meeting bankers to “Explain” what their plans are…..

  6. Bill Terrell says:

    I’ll defer to our UK correspondents on matters of UK politics, but from my more remote viewpoint it strikes me as odd that Truss is variously described as “conservative” and “libertarian” … it all looks profoundly Keynesian to me. Now the BOE rides to the “rescue” by “temporarily” suspending its QT program to buy gilts. Prices had plunged to the point the ten year was yielding over 4.5%. To become an enabler of fiscal profligacy would be disappointing but not surprising. Yet the plunge in UK bond prices admittedly has been so extreme that there is justification for at least tapping the brakes a bit.

    We should not be completely taken by surprise if this prefigures something vaguely analogous on the west side of the pond. The US Fed has been shockingly resolute in its inflation fighting role, but the pressure to relent is immense. Wall Street is practically in tears at the prospect of having to give up an iota more of its easy money and is begging for mercy. Add to that the more weighty matter of the free fall in UST prices. A further sharp selloff in stocks is likely all it would take for the FOMC to yield. It would legitimately satisfy its quest for “tighter financial conditions”, so that’s not all bad. Nevertheless if stocks were to go off to the races again it would have been all for naught.

    The action in UK gilts appears to have sent US Treasuries soaring. This is not surprising since we have been looking for a bottom in this time frame, although this rally is only one Fed speech away from being clipped. Yet the scale, speed and depth of the Treasury free fall has to be of at least some concern to a Fed that prefers incremental change. It’s not at all clear that even the most hawkish projections of Fed funds in the 4.5% range in the coming months justify ten year yields above 4%. Not that a ten year as high as 4.5% isn’t possible, but if that’s what it would take to let some more hot air out of still extremely inflated US stock prices, then so be it.

    1. Milton Kuo says:

      >Add to that the more weighty matter of the free fall in UST prices. A further sharp selloff in stocks is likely all it would take for the FOMC to yield.

      John Hussman’s most recent commentary stated that the expected yield of the S&P 500 in excess of the return on 10-year Treasuries is negative (-3.2%). The fall in equity prices since its top has been eclipsed by the bond market rout. It seems the Federal Reserve’s bubble-blowing has created a very nasty problem of a positive feedback loop.

      In the previous two cycles, as equities fell in price, bond prices went up which made equities relatively more attractive (expected returns on equities went up while yields on bonds went down). We are now in a situation where declines in equity prices are occurring in the context of falling bond prices. Equity prices are not becoming relatively more attractive than bonds as an asset class. Bond yields would go a lot higher if the Fed normalizes its balance sheet, which I don’t think it ever will.

      1. Bill Terrell says:

        Thanks for the thoughtful insights, Milton. Indeed bonds and stocks have been joined at the hip, though I suspect that may be about to change. And FWIW I completely agree the Fed will never normalize its balance sheet; the best we can hope for is for it to normalize rates … and even that may be only temporary … if it ever gets there for long it would likely be via a series of attempts … just as it did not establish the abnormal all in one blow.

  7. Mega says:

    Sorry Bill
    Got into this a bit deep, i try to cool my responses but WHAT A DAY!
    I NEVER known anything like this.


    1. Bill Terrell says:

      No worries, Mike. These tectonic developments merit a few colorful remarks to convey an appropriate degree of shock:-)

  8. Mega says:

    Just a quick update here in Blighty…
    Things steady right now, but the problems remain.

    1. Bill Terrell says:

      Not at all, Mike … much appreciated. For the sake of putting bits in context and finding them later though, it’s helpful to keep like subject matter together … so I’ve moved it to the article and comments already devoted to it.

      Interesting video … these guys seem to have a pretty good handle on what’s at stake. Everyone should be paying attention this … no one no matter what country they call home should imagine it can’t happen here.

    1. Bill Terrell says:

      Apparently the UK leadership has thrown in the towel on the tax cuts, ditching plans to eliminate the highest bracket. Not surprising since regardless of their long term merit or lack thereof, it’s extraordinarily poor timing.

      It should give the energy price caps the same treatment, though that would be much more politically difficult. Better to get to the root of the problem and reconsider the policies that are driving up prices in the first place.

  9. Llanlad2 says:

    Reverse Pivot!!! The financiers and pensions have had the legs kicked from under them despite their urgings.

    The BoE governor insisted the £65bn scheme to purchase UK government bonds would not be continued beyond the deadline on Friday.
    Pensions industry leaders and one of the Bank’s former deputy governors had earlier called for an extension to mop up the ongoing bond market fallout triggered by Kwasi Kwarteng’s ill-received mini budget last month.

    The central bank had started the day by saying it would revamp the scheme’s bond-buying firepower – within the existing timeframe – for a second time in as many days, warning there were still “material risks” in government debt markets affecting UK pension funds.

    However, it ended with Bailey saying the intervention must end this week, telling an event organised by the Institute of International Finance in Washington: “We have announced that we will be out by the end of this week. We think the rebalancing must be done.

    “My message to the funds involved and all the firms involved managing those funds: You’ve got three days left now. You’ve got to get this done.”

    1. Bill Terrell says:

      Thanks for the update! I was just about comment on this ongoing saga.

      Straighten me out if I’m wrong, but based on media reports here the core problem appears to be leveraged investments in the pension funds, so called “liability driven investments” or “LDI”. The BOE has essentially thrown the funds a little more rope to give them time to extricate themselves from these risky synthetic investments.

      The problem was baked in from the beginning. These aren’t actual assets as you and I know them, but derivatives structured to behave a certain way under certain conditions. One such condition being ultralow bond yields. What could go wrong?

      In other words, the funds couldn’t find actual assets that would allow them to meet their obligations, so some were invented. This was never a realistic model. If I decide I need 12% returns to allow me to retire, I can’t just go out and create assets to order. I have to choose from what’s on the menu. If I can’t make it work, I have to increase my contributions or dial down my retirement income expectations.

      The pension funds didn’t want to accept this reality, so the financial industry created a fantasy that would facilitate denial.

      Until reality inevitably reasserts itself.

      Now it appears the options are limited. The BOE can bail out the funds at the expense of the currency itself, or the bond market, or both, at risk of destroying the entire nation’s financial underpinnings. My take is it would be better to just leave the pension managers and their magic investment models to go out of business, and instead bail out the pensioners. It would be a lot less expensive in the long run. Subsidizing bad decisions just assures more of the same. At least this way the decision makers pay and the innocent pensioners don’t.

      The US should be paying close attention. It has serious pension funding problems of its own, and if it doesn’t put its house in order could be next.