UK instability could easily go global, State Street warns

What has happened has reminded us of this systemic risk, says Michael Metcalfe, the investment manager’s head of macroeconomic strategy.

Michael Metcalfe is the head of macroeconomic strategy at State Street Global Markets. Picture: Jane Dempster

Financial instability in the UK has reached a point where it could affect monetary policy, according to the head of macroeconomic strategy at State Street Global Markets, Michael Metcalfe.

Amid expectations of a further tightening in monetary policy and a resumption of active bond sales by the Bank of England after emergency support measures end this week, there’s a risk of a further dislocation in the UK Gilt market, with potential for systemic impacts on global markets, the London-based Mr Metcalfe told The Australian.

“Up until a couple of weeks ago, markets had passed the ‘stress test’ of significant monetary tightening and unusually high volatility in bond markets.

“What has happened … has reminded us of this systemic risk.”

State Street Global Markets is one of the world’s biggest foreign exchange brokers. In the UK Gilt crisis last month, the 10-year yield soared from 3.50 to a 14-year high of 4.59 per cent and the British Pound Sterling fell 8 per cent to a record low of $US1.035. That led the BoE to say it would buy Gilts on whatever scale is necessary to stabilise the market.

On Tuesday the 10-year Gilt rose 25 basis points to 4.47 per cent even as the BoE’s backstop remained in place, and it increased the daily amounts it was willing to buy in long-dated Gilts to £10bn ($18bn) from £5bn, until it ends the emergency support program, as scheduled, on Friday.

To minimise volatility when its temporary bond buying program expires and quantitative tightening resumes, the BoE announced a temporary repo facility, allowing banks and pension funds to use a range of collateral including corporate bonds to meet liquidity needs caused by strain on so-called “liability-driven investment” strategies.

Mr Metcalfe said that until the recent crisis, investors had assumed that the overwhelming policy response by central banks to the Global Financial Crisis and the subsequent European Financial Crisis, via what were at the time unprecedented rate cuts and bond buying programs, led by the Federal Reserve and the European Central Bank, had “sort of fixed all that systemic risk”.

“All that’s meant maybe is that the systemic risk has kind of shifted to different places,” he added.

When the BoE announced its emergency support for Gilts in late September, yields plunged and risk aversion in global markets temporarily abated as investors saw it as an effective measure.

But after falling back to 3.74 per cent, the 10-year Gilt yield bounced 81 basis points and the pound lost 4 per cent in five days, even as market pricing for the so-called “terminal” policy rate in the UK soared from 5.30 to 6.03 per cent by May versus the current target rate of 2.25 per cent. Combined with soaring energy bills, such a big rise in interest rates could cause a deep recession.

Analysts said that pension funds and others were scrambling to get out before the BoE support window closed, or worse still, the BoE now has a credibility issue.

“There was hope that this initial period of BoE support would stabilise the Gilt market,” Mr Metcalfe said. “There was also this question though of the time-consistency of it.”

“A central bank buying bonds one week for financial stability concerns, with the market knowing it will sell bonds in three weeks for policy considerations … unfortunately it looks a bit inconsistent.

He said the UK faced very significant stagflation pressure even before the Gilt crisis hit.

While the collateral repo arrangements will help, authorities need to restore credibility. UK yields rebounded recently as it became evident the BoE was buying far less than the maximum it had previously set, with the Wall Street Jourrnal noting that it only bought £853m on Monday.

If the volatility continues, Mr Metcalfe expects much more of a focus on the issue of systemic risk. “They control inflation, they support growth, but they also need financial stability. This is the first time so far this year that something has really broken

The crisis shows there are limits to how much rates can be increased to combat inflation. “As they go up, things are going to break, and then it’s going to be really key how central banks … respond to that,” said Mr Metcalfe.

The Gilt crisis so far is a local issue related to the way that UK pension funds hedge their interest rate risk via liability-driven investment strategies – but it has “knock-on effects into other markets, because obviously they needed to sell some of their assets globally,” Mr Metcalf added.

“For the moment, at least, that doesn’t look to be systemic … whether there’s something else that’s breaking, that might be more systemic, we don’t know,” he told The Australian.

“Broader measures of systemic risk are definitely flashing amber, but we don’t have anything flashing red yet to suggest that there is kind of more global systemic risk going on.”