The writer is managing director of global macro at TS Lombard
The UK is relevant again in markets. I have spent the last month fielding questions from international investors who, thoroughly bemused by events in Britain, wanted to know whether its turmoil signalled anything about the state of the world economy — whether it is a financial canary in the coal mine.
I tell them that the root of the UK’s problem was not its “fiscal black hole”, but investors’ realisation that the country was facing an imminent trade-off between financial and price stability. That is an issue likely to be confronted by other economies.
The unfortunate part of the story is that it has been credited to the mythical bond vigilantes. UK officials are now focused on whether a specific budgetary response will keep the markets happy by filling a hole in the public finances.
Apparently, global investors are no longer prepared to fund the UK’s deficits, so the government must win back their approval. While there is a sliver of truth to this, we must be careful not to assign a personality to markets, or to assume that the pricing of government bonds is designed to impose “discipline” on public decisions. This is not a morality tale.
Markets price probabilistic outcomes based on what is likely to happen — not what should happen. The big problem with the ill-conceived “mini” Budget was not its impact on the public finances per se, but rather the likely response from the Bank of England. Bank officials, already uber-hawkish, looked destined to jack up interest rates to levels that would cause stress in the property market. A looming financial crisis is not exactly bullish for the exchange rate.
The Treasury had put the BoE in a lose-lose situation, particularly with the US Federal Reserve still raising interest rates aggressively. It could let the currency slide, which would add to already extreme levels of inflation, or it could try to chase the US central bank in an effort to support sterling — but only if it was prepared to risk the fallout in the property sector and elsewhere.
From a global perspective, there are a bunch of economies facing the same dilemma — economies with high levels of debt, overpriced housing and an acute sensitivity to higher borrowing costs. One by one, the Reserve Bank of Australia, the Bank of Canada, the BoE and the Norges Bank have realised they cannot win a currency war with the Fed.
The UK drama highlights the importance of policy gradualism, not that governments must return to austerity. With much of the world headed into recession, there will still be a role for governments to support their economies with targeted fiscal interventions. Austerity is not the answer, but neither were large regressive tax cuts and a budget that displayed a bizarre ideological fetish for “trickle-down economics”.
With a more gradualist approach to fiscal policy, central banks — particularly those with vulnerable property sectors — can pursue a more reasonable monetary policy, rather than chasing the Fed in a race to see who can crash their economies first.
The fiscal-monetary “tug of war” is not going away — there will be plenty more demands on the public finances in the 2020s — but if either arm of government pulls too hard, the outcome is likely to be a highly destructive recession, perhaps even a financial calamity.
The other lesson from the recent UK crisis is about how the vulnerabilities in the financial sector have migrated from banks (the sell side) to institutional investors and “non-banks” (the buy side).
UK pension funds had been engaging in activities that made sense when interest rates were zero but became unsustainable as yields surged higher. As these institutions reversed these activities — through asset fire sales and the like — they amplified market volatility, creating a dangerous feedback loop.
These are dynamics we have seen before, specifically at the start of the Covid-19 crisis, and they seem endemic to the global credit system that emerged from the rubble of the 2008 crisis. Again, this is by no means a UK-specific problem. The good news is that central banks have a great deal of influence over the non-bank credit system and, as the BoE has demonstrated, can break these dynamics with relatively modest interventions.
But as the decade-long global search for yield unwinds, investors are facing serious losses. The challenge for central banks is whether they can make these interventions, putting a floor under markets, while simultaneously maintaining the monetary squeeze necessary to bring down inflation. It’s a difficult balancing act and fiscal policy going rogue obviously doesn’t help.