The wildest of rides
Keeping up to date with UK economics and politics over the past few months has felt a bit like riding a rollercoaster. And the scariest part is that we have no idea when the thrills and spills are going to end.
I’m sure many people would love to stop the ride and get off – or, at least, take a break to draw breath – but the big dips keep coming. And this week was the biggest yet.
Raining bombshells
As a recap for those who have been holidaying under the sea, the UK Government dropped a number of bombshells this week when it announced a mini-budget or, as it was rebranded (in an attempt to downplay its significance…) a “fiscal event”.
To say markets reacted unfavourably to Chancellor Kwarteng’s Growth Plan 2022 would be the understatement of the year.
On Monday, the pound had dropped to its lowest USD level ever, forcing the BoE to say it would buy Gilts to help "restore orderly market conditions". 30-year yields dipped back to 3.93% after they had risen to over 5%, the highest level since 2002. Wild doesn't even come close, and this incredible episode reminds me of that famous quote from James Carville:
“I used to think that if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.”
Investors, notably pension funds, sure were intimidated, and the economic repercussions and political fallout are being endlessly dissected across the press and on social media. For me, two things stand out.
A social construct
First, this is a harsh reminder that economics is not physics, and 2+2 doesn’t always = 4. Economics and financial markets aren’t mechanical systems, and while it may be confusing to accept, the same inputs will not always yield the same outputs.
It doesn’t matter how much calculus you apply to the field, an economy is fundamentally a social construct, and economics is a social science.
This means that markets and economies rely on the collective assumptions (and delusions) of a large group of differently-minded people. The whole thing “works” when there is belief. It falls apart when people stop believing. Back to 2008, Lehman didn’t go bust because it was insolvent - most of its real estate loans were bought and ended up maturing close to par. Lehman went bankrupt because it lost the confidence of the market, and as a consequence it ran out of short term funding. I remember the moment it happened - Sept 10, 2008, when they released [bad] earnings 2 weeks early to try and get ahead of the news cycle. The losses were bad, but more importantly, the management team on the call sounded haggard - tired, stressed, and without a plan. Over the next 2 trading days confidence evaporated, and Lehman lost the ability to borrow in the short term markets, forcing it to close.
Last week’s announcement by Kwarteng’s contained few surprises. The policies had already been briefed, mostly during the leadership contest that PM Truss fought with Rishi Sunak. The 45% tax cut is actually a drop in the ocean relative to the UK deficit. But, much like that early Lehman earnings call, Kwarteng’s “event” killed the market’s confidence in the UK government. Those of us who have worked in this industry for a time know how markets run on animal spirits, and those spirits go from greedy to fearful in an instant.
Friday’s announcement nudged the Jenga block and the whole thing fell. Once lost, real confidence is impossible to regain, and the market’s confidence in the UK evaporated into the cold autumnal air. Given that the Pound is not a reserve currency (like USD), falls in confidence can be much more dramatic (and potentially even irreversible), than falls in confidence in other countries.
The truth of rates
When I was at MIT, we used to joke that you could only have 2 out of the below 3:
Good grades
Sleep
An active social life
The UK’s folly should remind us of one piece of hard economic science with a similar choice. Western economies, regardless of size or location, can only have 2 of the below 3.:
Low inflation.
Low rates.
Expansionary fiscal policy (e.g. Biden’s Inflation Reduction Act, Truss’ energy price cap, etc).
Given how we all live in democracies, political realities mean expansionary fiscal policy will remain, regardless of whether or not the government can “afford” it. And we’ve had a huge spike in inflation, with the consensus being that needs to be dealt with, fast. This means that developed market interest rates are only going in one direction, and this is going to make borrowing – and bond issuance – incredibly difficult over the coming 12-24 months. Borrowers (including governments like the DMO) will be forced to be more reactive, creative, and tactical about when and how to issue, and what regions to target.
A helping hand
Given the 2-3 years we’ve had, it’s extraordinary to think how global finance and economics could turn even more mad.
But, this is 2022 and I’m afraid the rollercoaster, especially the British one being driven by Truss and Kwarteng, is going to keep on dipping and diving. Right now, I don’t see your wish to get off being granted anytime soon. The complacency of the last decade is over, and the life of a Treasurer or Funding Officer is only going to get harder.
One way to fight through the chaos (and a bit of a shameless plug which I hope you’ll forgive me after 900 words) is for the bond market participants to have better access to people, data, and streamlined processes.
I don’t want to say that Origin Markets have a solution that faces down the unparalleled intimidation of the bond market – but we like to think we can do a little to help. Get in touch if you’d like to discuss how.
