When Two Worlds... Collide?
How To Spook The Bond Market with a Brief Announcement
What was all that about?
Politics is an area I tend to steer away from, but it’s hard to ignore what did, and almost did take place in the UK markets over the past two weeks. I’ll speak about it briefly in this piece. If you aren’t subscribed already, hit the button below to receive insights and analysis every two weeks.
On 23rd September Liz Truss and UK Chancellor Kwasi Kwarteng announced a new set of policies as part of a ‘mini budget’ in a bid to ease the current cost of living crisis. Among those were a cut in the basic income tax rate from 20% to 19% and a removal of the 45% higher rate of tax - both unfunded, meaning the government would have to borrow money in order to action them. The markets reacted to the announcement - and boy did they react. The below graph shows the price movement of £1 against the dollar through September:
Source: Bloomberg
The Pound slumped against the U.S. Dollar and 2 days after the announcement, fell to an all-time low of $1.03 - with many fearing that we’d hit parity with the dollar (£1=$1). In other words, foreign investors ran for the hills and the pound became far less valuable against the world’s reserve currency.
What followed was even scarier - UK government bonds were being sold off at an alarming rate - so alarming that just 5 days after the budget announcement, the Bank of England themselves announced an emergency temporary bond-buying operation; to the tune of £65bn; to stave off a “material risk to UK financial stability”. This risk arose because pension funds were being asked to post large amounts of collateral to satisfy margin calls that they could not meet, and had the Bank of England not stepped in, many could have gone under. Word on the street is that this operation needs to continue for a good few weeks at least to have the desired effect.
It’s hard to understand the tax cut in this environment. One of the Bank of England’s prime objectives is price stability, so in a period of rising inflation, you’d expect them to increase interest rates in a bid to keep inflation down. This is what they have done this year, with the base rate having gone from 0.25% in January to 2.25% now, with every chance that rate increases will continue through the end of the year.
Source: Bloomberg
Contrast that with the governments mini-budget announcement. With UK inflation in the double digits, how does scrapping the 45% higher tax rate make any sense? Scrapping tax rates in essence encourages further spending, which seems counter-intuitive to rising inflation in this environment. The government and the Bank of England would not have been seen to be working in tandem, so if fiscal and monetary policies could have potential opposite effects, it’s no wonder why the markets were rattled.
A week later, the government reversed the tax cut plan due to the market reaction and general dismay and since then, the pound has almost regained September’s losses. To be fair to them, having the ability to change your mind in the face of new evidence and criticism is admirable. However, it’s difficult for investors to have confidence that the government is serious about the Bank of England’s goal of cutting inflation. Criticism has been widespread, with even the International Monetary Fund (IMF) Economic Counsellor chipping in, likening the policies as 2 drivers, each with their own steering wheels. Ouch.
That said, the madness in the UK markets over the past few weeks is merely a microcosm of all that’s happening worldwide and its effects on global markets as a whole.
The Big Short(er)
While long-only bond funds suffered from the fallout of the mini-budget announcement, some hedge funds betting against the pound have seen some gains this year. Odey Capital Asset Management is one of those funds and their flagship fund is up 193% this year alone. It’s quite ironic that Crispin Odey, the founder, had Kwasi Kwarteng working under him for some time before becoming an MP. Anyway, what’s my own?
Until next time!
Disclaimer: None of the information published constitutes as financial advice or recommendations. All investments involve risk and the past performance of a security or financial product does not guarantee future returns. Please be sure to always do your own research and/or seek professional financial advice before buying or selling any securities.