The RSM UK Financial Conditions Index is warning of a dramatic increase in credit risk that, along with the depreciation of sterling, has the potential to derail commercial activity in the United Kingdom.
One gets the sense that a potential breaking point is approaching in the U.K.
Growing financial stress has exposed the difficulties that global central banks face in balancing growth, inflation and financial stability.
As central bankers grapple with this quandary, one gets the sense that a potential breaking point is approaching in the U.K.
Can the Bank of England stabilize the financial markets and throw a lifeline to the new Tory government that appears to be stumbling out of the gate? We will most likely know in the next few days.
In recent commentary, Adam Tooze, a Columbia University history professor, suggests that six years after the Brexit referendum, financial markets are finally catching up to the potential damages to the U.K. economy.
No matter how earnest, criticism of Tory policy is “a ritualistic discourse through which the guardians of norms reassure themselves and the rest of the world of who is in charge, and what the rules are,” Tooze wrote.
Moreover, he asserted that Prime Minister Liz Truss and Chancellor of the Exchequer Kwasi Kwarteng know exactly what they are doing, and that neither needs to hear from the economic community about what they should be doing.
With the government giving preference to what it thinks will grow the economy, the central bank will be faced with a monetary policy at odds with the fiscal position of the government. The bank will have untenable choices, whether those are between rate hikes and higher inflation, or a stable set of financial conditions and providing liquidity to market participants.
Time will tell if the government does in fact address the market’s concerns and finds a way to gracefully alter its policy course. But given Truss’ insistence that she will not reduce expenditures or reverse course on tax cuts beyond what she has conceded, it is difficult to see how Kwarteng will square the circle by Oct. 31, when the budget is due.
In the meantime, the markets have made clear their displeasure with political events and the direction of public policy. With the benefit of hindsight, the markets are disappointed with the speed at which the nonpolitical monetary authorities have responded to inflation.
Divergence in the money markets
This mismatch in policy objectives seems clear in the rapid divergence between commercial interest rates—proxied by the so-called euro-pound rate—and the risk-free Treasury bill rate.
The mismatch in policy objectives seems clear in the rapid divergence between commercial interest rates and the risk-free Treasury bill rate.
The cost of commercial borrowing that had increased to 2.6% in the first week of September shot up by an additional 110 basis points to 3.7% by the end of the month.
All the while, the three-month Treasury bill rate increased by only 20 basis points from 2.3% to a still modest 2.5% for a rate spread of nearly 130 basis points.
The spread only rarely reaches this level. Previous instances include the 1997-98 Long Term Capital Management crisis, the 2008-09 financial crisis, the 2010-12 European debt crisis and the 2020 pandemic shutdown.
Commercial activity is just not possible without a functioning money market, and the rapid widening of this money market spread is cause for concern.
A bond market growing impatient
There is also increased tension in the bond market. By the end of the summer, the front end of the UK yield curve was anticipating additional rate hikes by the Bank of England, with two-year bond yields rising to 3%. Five-year yields were also moving higher, but it seemed a more orderly selloff, with a positive yield curve out to 30 years’ maturity.
After decades of slow-moving changes in fiscal policy and low inflation, it seemed inconceivable that the bond market would ever again sell off in a hurry.
But two weeks into the new government, fiscal responsibility was thrown out the window. Add that to the economic strain surrounding energy, housing and inflation, and you’re asking for a bond market selloff.
With the economy already slowing down and reducing future tax revenue, where would financing for energy subsidies come from if tax cuts for the wealthy were enacted?
The market answer for all the uncertainty was to demand higher compensation for holding long-term maturities. There was too much risk of inflation remaining high, or that the energy crisis would affect economic growth and Bank of England policy.
U.K. two-year yields rose by 160 basis points in September, the five-year increased by 180 basis points, and the 10-year and 30-year each rose by 150 basis points (all in round numbers).
The monetary authorities
At the short end of the bond market curve, there is speculation that the Bank of England will not wait until its next scheduled Monetary Policy Committee meeting on Nov. 3 to raise its overnight policy rate.
It’s unclear if the committee feels compelled to keep up with money-market expectations or instead will opt for orderly increases. We would put money on a mid-meeting rate increase if the bond market mayhem were to continue.
As for longer-dated securities, the Bank of England has already announced a pause in quantitative tightening and the temporary resumption of its quantitative easing program of buying and holding fixed-income securities.
The central bank cited the significant repricing of U.K. and global financial assets that is affecting long-dated U.K. government debt in particular.
If dysfunction in this market were to continue, the Bank of England points to material risk to U.K. financial stability and a reduction of the flow of credit to the real economy. Our financial conditions index is already pointing to that risk.
As such, the central bank said it would carry out temporary purchases of long-dated U.K. government bonds to restore orderly market conditions, and that these purchases will be carried out on whatever scale is necessary to effect this outcome. But the bank has also insisted that its intervention in the gilt markets will end on Oct. 14.
These seemingly mixed messages from the central bank have added to the general sense of confusion and risk aversion in financial markets.
Note that the Bank of England’s holdings of government securities (and to a lesser degree corporate bonds) had dropped from a peak of nearly 875 billion pounds by the end of last year to roughly 840 billion pounds in the third week of September.
Bank purchases reduce the supply of bonds available for purchase, driving up the price and lowering the interest rate. The lower supply of fixed-income assets and lower return would theoretically incentivize investment in other assets and add to economic growth.
Finally, there is the problem with the pound, and more generally the problem of dollar strength and increased dollar-priced energy costs.
The Bank of Japan’s intervention in the currency markets, which attempted to put a floor under the yen, looks as if it has failed. The yen has moved back above 146 to the dollar, which is where the Bank of Japan has traditionally intervened to prop up the yen.
But it seems unlikely that the Bank of England would follow suit. According to our analysis of International Monetary Fund data, U.K. holdings of foreign exchange reserves have been in decline since 2018. Japan and other Asian export-heavy economies are the ones that would be able to engage in significant currency intervention.
It would take a joint intervention by the nations in the G-7 (which includes Japan) to enact a serious change in currency valuation at this point. But any effort by the Federal Reserve or the United States Treasury that might be construed as weakening the dollar would feed into an uproar of disapproval by the significant slice of American voters who already insist that the dollar is weak.
If there were to be a concerted intervention effort, it would have to come after the November midterm election in the United States. But even that might be too close to the 2024 election.
The takeaway
It took years after the Plaza Accord in 1985 for the impact of the Federal Reserve’s rate hikes under Paul Volcker and the attractiveness of the 1980s U.S. financial markets to wane and upend the attractiveness of the dollar. And it took years after the Louvre Accord in 1987 and the flood of investment during the dot.com years to restore the dollar’s value.
We’d argue that the appetite among the G-7 for currency market intervention has waned. Messing with the free flow of funds can have unintended economic and political consequences. The metaphor is putting the genie back in the bottle.
For the U.K., we would argue that it needs to reconsider its relationship with Europe, its closest and largest trading partner. The dominance of the pound ended long before the Bretton Woods accord of 1944.
