“There are decades where nothing happens; and there are weeks where decades happen.”
UK’s wake-up call on bond vigilantes
In conversations with investors about the stunning scenes in UK debt and currency markets since the government’s “mini” Budget, two names keep cropping up.
One is Warren Buffett. As far as we know, the 92-year-old “sage of Omaha”, chief executive of Berkshire Hathaway, did not have a direct hand in chancellor Kwasi Kwarteng’s big reveal of unfunded tax cuts and supercharged borrowing from the bond markets.
But Buffett’s observation — one of the most famous in finance — that “only when the tide goes out do you discover who’s been swimming naked” is very apt. In this case, the skinny dippers include the operators of pension funds’ generally perfectly prudent hedging strategies, which briefly turned toxic when UK government bond prices tanked far faster than stress testers had imagined possible.
The other name that keeps coming up is James Carville, once an adviser to US president Bill Clinton, who said in 1994 that he would like to be reincarnated as the bond market, because “you can intimidate everybody”. Like the Buffett quote, this quip is famous in markets. Both are so widely used because of the truths they reveal.
In the “mini” Budget drama, it was UK government bonds that really shook the system. Sterling’s precipitous dive to record lows on the Monday after Kwarteng’s speech was a sign of a country rapidly falling out of favour with international investors.
It is no coincidence that these days Sky News places a widget showing sterling’s exchange rate against the dollar in the corner of the TV screen for UK political news bulletins. But, as Carville would recognise, the UK government bond market was much more frightening.
Bond investors balked, prices dropped fast and technical factors relating to pension scheme hedges quickly made matters worse. This, not the pound, is what forced the Bank of England to step in with a targeted rescue programme. The intricacies of bond yields rarely trouble the general population, but homeowners quickly figured out what this meant for mortgage repayments, making it a searing political issue.
Plus, it all jacks up the price tag for the government’s plans, ultimately forcing the chancellor to back down on some elements. All of a sudden people get why bonds, and bond investors, matter.
The bond vigilantes are back,” says Gordon Shannon, a fund manager at TwentyFour Asset Management. “If governments have a plan, they need to think about market reactions.” Governments were largely able to ignore markets in the period after the financial crisis as central banks pushed borrowing costs ever lower. Policymakers’ long fight with low inflation (remember that?) meant governments could always borrow on the cheap. Complacency set in.
High inflation has changed all that. Now, investors are much more fussy. “Companies that can sell their story can finance themselves at a better cost,” says Shannon. “This has not been part of a politician’s job for 15 years. It just has not been part of the game.”
Now that it is part of the game again, it is worth looking at what investors did not like. Governments should note that it was a mix of style and substance. “In my mind, this is a trust and confidence issue,” says Sondre Solvoll Bakketun, a bond fund manager at Norwegian investment house Skagen Funds.
“Having all that inflationary pressure and then more spending is generally not a good idea.” Investors agree, though, that the real sticking point was the lack of oversight from the Office for Budget Responsibility, the independent body set up to scrutinise public finances. “I think it was the way it was presented,” said César Pérez Ruiz, chief investment officer at Pictet Wealth Management. “You need someone with credibility to come back and validate your plan.”
Making matters worse, Kwarteng’s repeated assertions that “markets will do what they will” gave investors the impression that authorities were happy to see bonds and sterling drop. “It said to markets ‘if you think it’s not right, have a go’,” says Pérez Ruiz. It took several days for Kwarteng publicly to acknowledge that the market ructions had “ruined his sleep”.
Now, as the BlackRock Investment Institute pointed out, credibility has been damaged, with real-world implications. “The sharp rise in UK gilt yields showed how higher rates can cause financial dislocations and disruption,” wrote the institute’s head Jean Boivin and deputy head Alex Brazier. “The UK is offering us a glimpse of the future for others.”
European officials reacted with a fair amount of schadenfreude to the UK’s financial market woes, but some countries might find themselves in similar quandaries soon, in turn forcing central banks to decide whether to keep firing up rates to quash high inflation or to restart support for fear of nasty financial accidents.
Better communication would help governments to keep markets on-side, but they must remember they are playing to a tough crowd. “There is a limit to everything,” says Pérez Ruiz. “The UK was a wake-up call for the rest of the world that the market can say ‘enough’.”
katie.martin@ft.com
The bond vigilantes vs Liz Truss Guess who’s back, back again
The famed bond vigilantes are back. They just stopped by last week to visit with the UK’s new Conservative government headed by prime minister Liz Truss. They showed up unexpectedly and unannounced.
I first wrote about them all the way back in the July 27, 1983 issue of my weekly commentary, which was titled “Bond Investors Are the Economy’s Bond Vigilantes.” Back then, there was lots of concern in the US that the Federal Reserve might not stay the course in fighting inflation. I concluded: “So if the fiscal and monetary authorities won’t regulate the economy, the bond investors will.”
The bond vigilantes’ heyday was the Clinton years, from 1993 through 2001. Placating them was front and centre on the administration’s policy agenda. Indeed, Clinton political adviser James Carville famously said at the time, “I used to think that if there was reincarnation, I wanted to come back as the President or the Pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody.”
Today, prime minister Truss would do well to heed Carville’s admonition! The UK government is spending a lot of money that it doesn’t have, and the bond vigilantes — already on alert due to high inflation — aren’t going to stand for it. The recent moves have been extraordinary.
In early September, Truss announced a plan to spend billions of pounds to subsidise citizens’ energy bills. Then last week, the UK’s Chancellor Kwasi Kwarteng proposed a plan to boost the economy by cutting taxes and borrowing lots of pounds to pay for them. This flies in the face of the Bank of England’s efforts to tame inflation.
So the fiscal authorities want to put the pedal to the metal at the same time that monetary policymakers are tapping on the brakes. That’s a sure why to have an accident. And, sure enough, the foreign exchange value of the pound and UK bond prices have crashed. By Wednesday, the BoE was forced to say that it would buy as much government debt as necessary to stabilise the bond market.
Most central banks, including the BoE, have made a commitment to target inflation at 2.0 per cent. Despite dipping slightly in August, the UK’s inflation rate is currently at 9.8 per cent, up from 3.2 per cent a year ago. So, the BoE started raising its official interest rate starting on December 16, 2021 and is expected to continue hiking it. More deficit-financed spending and tax cuts are bound to add more fuel to the UK’s inflationary fire.
The BoE was established in the late 1600s to be the banker for the English government, supporting and financing its policies without questioning them. In recent years, the BoE and the other major central banks have touted their political independence.
But in practice, central banks sometimes have no choice but to accommodate the reckless fiscal and regulatory policies of their government. That’s because central banks all have an implicit if not explicit mandate: to maintain financial stability.
We saw that on Wednesday, when the UK central bank suspended “quantitative tightening” and announced plans to buy long-term bonds instead. The BoE’s QT plan — which was slated to start next week — involved selling its holdings of government bonds as part of the effort to reduce UK inflation. Post-pivot, the BoE now plans to buy long-term bonds through mid-October. The central bank said that it would make purchases at “whatever scale is necessary” and that the UK Treasury would cover any losses — a pretty stark volte-face.
The bond vigilantes were last active during the 1980s and early 1990s. They’ve been mostly lying low since then. That’s partly because inflation remained remarkably subdued from the mid-1990s through 2020. Furthermore, in response to the financial crisis and then the Covid-19 pandemic, central banks kept the bond vigilantes in check with their zero-interest, negative-interest-rate, and quantitative easing policies.
No more: Inflation came roaring back in 2021 and 2022, forcing central banks to tighten their monetary policies, while fiscal policies continued to run amok. Once the central banks were forced to stop their “Great Financial Repression”, the bond vigilantes were set loose.
Since the pandemic, they’re back in the saddle again and riding high because of the excessively stimulative fiscal and monetary policies promoted by liberal modern-monetary-theory zealots in the US and now conservative supply-sider proponents in the UK. For the sake of financial stability, central banks may have no choice but to intervene in markets to avert a financial meltdown. But now both monetary and authorities are on notice: The bond vigilantes are back, and they are intimidating.