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UK: Crisis, Division, Uncertainty, Distrust

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The UK’s crisis of confidence is deepening, and as the BoE insists its emergency bond buying program will end today, pension funds continue to frantically try and raise cash. A flurry of rumors added to volatility in markets this week, and pressure on PM Truss to rewrite her fiscal plan is mounting.

We’ve seen another week of attempts to calm markets, but so far without much success and the situation is still very fragile and markets are nervous.

Today, meanwhile, UK PM Truss sacked the Chancellor and prepares a U-turn on Kwarteng’s unfunded tax cuts. Kwarteng flew back early from the finance ministers meeting in Washington and while there were initially speculations that he would work on updates to his fiscal plan, the FT had reportedly earlier that Truss would actually sack the Chancellor. cable had rallied to session highs near 1.14 on the initial reports, but dropped back to under 1.12 on confirmation that Kwarteng is gone. Yields remain sharply down on the day as markets wait for Truss’ new updated fiscal plans.

At the start of the week, the Treasury gave way, and Chancellor Kwarteng announced that he would bring forward the publication of his medium-term fiscal plan to October 31. Unlike the mini-budget, the full fiscal plan would lay out medium term plans on how to cut UK government debt, backed up by official forecasts from the OBR (Office for Budget Responsibility). That announcement came alongside fresh intervention from the BoE, which topped up the daily bond buying target to GDP 10 bln. They included index linked Gilts in the buying spree, and they also announced a new short term lending facility that allows banks to borrow cash against their bond holdings.

In the meantime, the new Temporary Expanded Collateral Repo Facility (TECRF) will run until November 10, and it will greatly expand the pool of assets the BoE will accept as collateral. As the FT pointed out, it will allow “banks more flexibility to accept a broader range of collateral from in pension funds using LDI schemes”. Concern of wider risks at pension funds that use so-called liability driven investment strategies had been at the heart of the current crisis, as many face liquidity problems in light of the sharp rise in yields.

Pension funds reportedly also urged the bank to extend its asset purchases. Bailey warned funds that they had “three days left” before the end of the central bank’s emergency bond buying program. This was followed by an FT report suggesting that BoE officials had signaled privately in discussions with bankers that the program could be extended after all. That in turn was promptly denied by Bailey who insisted the program will end as planned today.

The confusion played into the government’s hands, with Kwarteng setting Bailey up to take the blame, if the end of the BoE’s program on Friday were to trigger a fresh wave of turmoil. However, while the conflicting headlines clearly didn’t help, and markets are bracing for a “cliff-edge” scenario if bond buying really ends on time this week, it is clear that the real problem remains the government’s fiscal plan. It didn’t help today that the government’s Business Secretary, Jacob Rees-Mogg seemed to imply that Kwarteng should simply ignore the OBR’s fiscal projections and stick to his plans.

Markets have and will remain volatile, and pension funds are nervous. They now have two weeks to try and raise cash by selling off UK government bonds and index-linked and corporate bonds. With rates still rising, the fundraising task is intensifying. A Reuters source story highlighted that providers of liability driven investment strategies (LDI) are now demanding cash buffers that “are about three times larger than previously requested”. The BoE has pointed out that the special repo facility will remain in place until November 10 and should help to smooth over the transition next week.

Whether this will be enough remains to be seen, but the ball is now back in the government’s court. While officials have continued to rule out further changes to the fiscal plan, there were plenty of reports suggesting that the government is secretly preparing a U-turn on the corporation tax, which could rise to 25% from 19% after all. If Truss fails to deliver, pressure will build again, especially if the BoE sticks to its guns and doesn’t extend the bond buying program. The head of the IMF also stepped into the debate again today and repeated that fiscal policy “should not undermine monetary policy”, while telling the UK “not to prolong the pain” and to ensure that “actions are coherent and consistent”. This won’t go down well in Westminster, but very much goes to the heart of the problem.

Consumers meanwhile are facing more pain. The government’s energy price guarantee may cap bills to a certain extent, but with mortgage offers pulled and rates rising fast, the BoE’s Financial Policy Committee said: under the assumption that rates follow the market implied path “the share of households with high cost of living-adjusted mortgage debt-servicing ratios would increase by end-2023 to around the peak levels reached ahead of the global financial crisis (GFC)”. The bank still argues that “households are in a stronger position than in the run-up to the GFC, so UK banks are less exposed to household vulnerabilities.”

Indeed, there are fewer households with mortgages than at the time of the GFC and the ratio of debt to income of British households is well below where it peaked before the 2008 crash. Nevertheless, even the bank admitted that “it will be challenging for some households to manage the projected rises in the cost of essentials alongside higher interest rates”. Consumers are now also facing the risk of falling house prices and an erosion of pension pots on top of the cost-of-living crisis.

Many think that the situation carries the seeds of a much wider financial reckoning, revealing major vulnerabilities in the so-called shadow banking sector that controls trillions in assets globally. The assumption that government bonds are “ultra-safe” may be correct in the long run, but this year’s developments have shown that they are not immune to a sudden sell off. In this situation, many feel that the turmoil in UK markets is a sign of what awaits global markets.

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Andria Pichidi

Market Analyst

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