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Time to Pay The Piper

uk economy decline

Many of you have of course been aware of the crisis in the UK government bond market following Chancellor Kwasi Kwarteng’s recent minibudget, in which more tax cuts and government spending were promised. The UK government bond market or Gilt market, is the market in which the government taps investors worldwide for funds and in exchange, investors receive a bond with a promise of interest payments every six months with repayment of the full principal at the end of the term. Many will say that Kwarteng’s mini budget was the reason behind the crisis as the price of Gilts crashed and yields spiked massively. My argument will be that this crisis had been brewing for decades and that the mini budget was the straw that broke the camel’s back.

Let us look at what it means when Gilt prices crash and yields rise. When HM treasury needs to borrow £1 billion it will go into what is called the primary market and issue a bond or Gilt at auction, and investors will offer to pay a certain interest or coupon. The secondary market is the market in which the Gilts trade amongst investors after an auction, so when prices start dropping precipitously and yields start rising, it means investors require more interest for holding Gilts. There are a few reasons why this might happen – The first one is a rise in inflation like we have seen recently to sound 10%. For most of 2021 the 10 year Gilt yield was below 1% while inflation as measured by the CPI ran at 5.4%. So why would any sane investor accept a 1% interest payment from HM Treasury when the currency is being debased at a rate of 5.4%? Probably because investors thought the Bank of England and the government would sort their affairs and control inflation and fiscal spending. The other reason investors might want to sell Gilts in the secondary market is if they are for foreigners whose currencies are rapidly appreciating versus the British pound.

So why have things suddenly gone from a relatively stable Gilt market at the end of 2021 to total chaos in 2022? I would say that the underlying reasons are the inflation situation and the fiscal profligacy of the UK government ever since the 2008 crisis. Sure, the breakout of the war in Ukraine in February this year helped push energy prices higher, but they were already rising prior to 2022 and as we saw, above inflation was already pushing above 5%. The Bank of England held off raising interest rates from almost zero (stayed below 1% since 2009) up until the end of the year, despite about half a trillion pounds of Quantitative Easing (QE) during the pandemic and all the government spending during the same period. I warned you of this through my articles here that QE or money printing out of thin air would lead to higher prices, but the mandarins of Threadneedle Street thought money printing was not inflation!

The Bank of England continued to raise rates this year but not nearly enough to keep pace with double digit price rises. Their excuse was that inflation was being pushed up by Putin and his war on Ukraine, so the Gilt market was not too concerned but the 10 year Gilt yield went from around 1% in the beginning of the year, to around 2.75% by June. Investors still seemed to be giving the Bank of England the benefit of doubt despite CPI escalating to 12.7% annual rate in June! Don’t forget even with CPI running at 9.9% in August the Bank of England base rate was still below 2% at 1.75%, so foreign investors also started selling the currency – and that is why the rout in Gilts in late September corresponded to an all-time low for the pound of around $1.03 late on Sunday night of September 25th. The mini budget on the 23rd and the £150 billion energy package announced a couple of weeks before did not help investors’ confidence in the currency nor Gilts either.

The turmoil in the Gilt and currency markets meant the 10 year Gilt yield rapidly rose to around 4.75% by the end of September. This led to chaos in the defined benefit pension industry, the mortgage market and potentially a lot of other sectors of the economy that we will probably find out about in the coming weeks and months. The reason mortgages and all other borrowing rates in the economy have been affected is that Gilt yields or what the government needs to pay to borrow, is the benchmark for all other rates and they follow the Gilt yields either up or down. The Bank of England had to come out in late September and announce £65 billion to stop a total meltdown of the UK financial system even though they were supposed to be doing the opposite which is QT (Quantitative Tightening) or selling Gilts from their balance sheet. The Gilt market and the currency have stabilised for now and the Bank states the temporary QE ended on October 14, but I am not too sure we are out of the woods yet.

My conclusion is that we have had a period of 40 years in which interest rates have been falling despite a huge build up in credit and debt. It has generally been a period where most including governments, corporations and households have been able to easily buy now and pay later with no regard to tomorrow as asset prices like houses, stocks and bonds kept going up. Inflation had, up until recently, been fairly much under control, if you think 3% inflation is a good thing. There is an old saying that all good things eventually come to an end and this case my view is that we will face a new world in the coming decade plus and that will be a world in which working, producing, saving and then spend a little of what is left after expenses will become the norm. Maybe it will be a good thing to move away from a world of instant gratification and heavy debt loads? After 40 years of easy money, it is time to pay the piper.

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