Britain’s financial disaster is a warning to the world

Is the UK the first victim of the newly-awakened bond vigilantes – investors who punish spendthrift governments with higher borrowing costs?

Britain’s Prime Minister Liz Truss. Picture: AFP

A toxic mix of politics, inflation and higher interest rates is threatening the financial system in the UK, sending a shockwave through global markets and providing a warning to governments everywhere of the dangers of the new economic era we are entering.

A surprise tax cut by the new British government just over a week ago sparked investor concern about the country’s fiscal credibility and crashed both the pound and the market for UK government bonds, known as gilts.

Superlatives are a dime a dozen in market reporting, but the ructions in the past week were truly extraordinary. As well as giant swings in the pound, the longest-dated gilts, which mature in 50 years, lost a third of their value in four days. They then leapt in value by more than a quarter in a day after emergency bond-buying by the Bank of England designed to prevent a cycle of forced selling by pension funds. For context, the previous biggest move down over four days had been half as big, and the biggest daily gain was 15%, both when pandemic lockdowns shut the economy.

Such big moves had a direct impact on world markets, pushing up the dollar and Treasury yields and hitting stocks and commodity prices. The bear market took another leg down.

London’s position as a major financial centre and base for global investors, plus the sterling-dollar exchange rate’s role as the world’s third most-traded currency pair, often give it an out-size impact on global markets. But there’s also a bigger worry: Maybe the UK is the canary in the coal mine, giving advance warning of dangers that other developed markets face too.

The dangers are threefold. In the short run, is the UK a special case, or just the first victim of the newly-awakened bond vigilantes (investors who punish spendthrift governments with higher borrowing costs)? In the long run, is the UK once again taking to an extreme an approach – loose fiscal policy, and so more inflationary pressure – that is set to become the new new normal?

Finally, the old saw has it that the Federal Reserve hikes rates until something breaks. The Fed’s role in all this is that its shift to much higher rates helped the dollar to soar, hitting sterling and lifting global rates even before the tax-cut-driven sell-off. Now something has broken, and maybe other things will fall over too.

To address the short-term issues, start with what went wrong. The trigger was the government’s surprise unfunded tax cut, to the tune of about 1.8% of GDP a year, with the well-off benefiting the most. In the grand scheme of things it isn’t that much. But the cut had such a big effect because of the broader background of soaring interest rates, high debt, dire communications and the erosion of the country’s institutional credibility. Most of those issues apply, to a greater or lesser degree, across the developed world.

Interest rates are up almost everywhere, which has investors on edge. Borrowing to stimulate the economy when inflation is in double digits and the central bank is raising rates to try to slow things down puts monetary and fiscal policy at loggerheads, and means the Bank of England has to do even more. Europe has taken the approach of spending more, rather than taxing less, with its €750 billion Next Generation EU stimulus just getting underway.

The US has moved away from fiscal support, after Senate opposition to President Joe Biden’s Build Back Better plans and the inflation that resulted from last year’s monster stimulus package. Part of the original plan ended up in the more fiscally balanced Inflation Reduction Act.

Britain’s Treasury offices in central London. Picture: AFP

In Britain debt, was already due to leap due to the expected £150 billion-or-so subsidy of energy costs for households and businesses, from a base of 95% of GDP last year. That was the largest subsidy of any country in Europe until Germany went even bigger on Thursday, amounting to 6.5 per cent of UK GDP, according to Brussels-based think tank Bruegel. The markets weren’t bothered by the subsidy though, because it is a one-off to offset the leap in energy prices due to Russia’s invasion of Ukraine; the tax cuts and the associated loss of government income are meant to be permanent, hence the rush to sell.

Making the debt situation worse is the fact that Britain’s having to borrow from foreigners, as it runs a gigantic current account deficit. It retains a key feature of developed markets, borrowing in its own currency. But the more it has to borrow, the lower the currency has to go, or the higher the interest rate has to go, or, this past week, both, to attract overseas lenders.

The communications around the tax cuts were truly awful. The government chose not to explain the impact on government finances, merely talking up its ambition to have higher growth, something it argued the tax cuts would help deliver. Economists, and investors, disagreed. Prime Minister Liz Truss stayed silent for days after the market’s atrocious reaction, then tried to blame the plunge in UK assets on global factors. Denial of what every investor can see to be true is a poor strategy for winning hearts and minds.

The institution that would usually examine new tax and spending plans, the Office for Budget Responsibility, was sidelined, not being asked for the usual advance assessment.

Ms Truss had spent much of the summer attacking the UK treasury’s orthodox approach to economics – an approach that had reassured bond markets, but that she blamed for Britain’s sluggish growth of the past decade. The head of the treasury was ousted as one of the government’s first acts, a highly unusual move in Britain’s nonpartisan civil service.

“First you have Brexit, then you had Boris [Johnson, the last prime minister], and then there was this idea of a return to normality” with Ms Truss, said Richard Robb, co-founder of New York and London-based fund manager Christofferson Robb & Co. “And then: no, wait, it’s not returning to normality.” Other countries struggle with some or all of these issues. But no other major economy has been so cavalier about what the markets want, and the UK gives other leaders an object lesson in why they should be careful. Britain may be the canary, but its wobble is a warning to other countries to treat the bond markets better.

The answer to the long-term question seems clearer: Yes, there will be more inflationary pressures everywhere in future. Britain was the exemplar of the post-2010 secular stagnation, when growth was slow in spite of very low interest rates. The UK took austerity further than other large countries as it cut spending to run a very tight fiscal policy, which the Bank of England attempted to offset with record-low interest rates to support the economy. Ms Truss, who loves to model herself on tax-cutting former PM Margaret Thatcher, may end up as the exemplar of the opposite approach, as her unfunded tax cuts promise to loosen the purse strings for many years ahead – and bring much higher interest rates.

Until recently markets disagreed and priced in a future of very low global interest rates, after accounting for inflation, just as during the secular stagnation era that followed the 2008-09 recession. Inflationary pressures may be high, but were thought to be temporary. That has shifted in the past few months, with long-term real yields on US Treasury inflation-protected securities soaring as investors bet that inflationary pressures will force central banks to keep rates higher for the foreseeable future.

Investors should care a lot. A return to what was once known as the “new normal” of superlow rates means big profits for holding Treasurys and growth stocks such as the big technology firms. A future of more inflationary pressure and higher rates promises to hurt Treasurys and growth stocks, with cash the most obvious winner and cheap “value” stocks doing well relative to the rest of the stock market.

Pedestrians walk past a board displaying the price of Euro and US dollars against British pound Sterling. Picture: AFP

The most apocalyptic risk is that Britain is merely the first major victim of higher rates. Previous Fed tightening cycles often created financial problems, most obviously the global financial crisis that began with the subprime implosion of 2007, but also repeated emerging-market crises, the blow-up of hedge fund Long-Term Capital Management in 1998, and the implosion of the overnight borrowing market in September 2019. When easy money goes away, bad things happen.

How bad? It is always hard to predict, since we don’t know what hidden risks we don’t know. The banks are in much better shape than in 2007, but the Bank of England just had to step in to prevent problems in fully-hedged pension funds, a deeply dull sector few would have expected to implode.

As often happens, it was problems in an area regarded as safe that caused difficulties. A pension-fund strategy designed to cushion the impact of interest-rate movements faltered as rates surged and bond prices fell, driving prices still lower.

“It brings back the unknown unknowns,” said Goldman Sachs Chief Economist Jan Hatzius. “There could be other things out there along those lines. That’s definitely an issue.” Larry Summers, former Treasury Secretary and a Harvard professor, says there are parallels to 2007, when the subprime mortgage crisis began.

“When there are tremors there aren’t always earthquakes, but there aren’t earthquakes without tremors,” he said. “And there are certainly tremors.” Maybe there will be no more seismic events, and Britain’s problems will turn out to be nothing more than a small earthquake, not many hurt. Nowhere else has the exact problems Britain has, and nowhere else have politicians been so willing to risk the wrath of the markets. I don’t expect anything on the scale of the financial crisis to hit. But times are hard, the dangers are mounting, and it would surprise me if we came through the next couple of years without at least a few more minor crises, and probably more central bank rescues.

DOW JONES