For all the attention grabbed by sterling’s wild gyrations in the three weeks since the chancellor’s mini-budget, the real action has been in the market for British government bonds, known as gilts. The pound going up or down a few percentage points does matter: a weaker pound increases the cost of imported goods such as energy and food, and feeds through into inflation and living standards. But those impacts pale into insignificance compared with the pain that can be delivered by the gilts market.
Over the last month, the price moves in this market have, in the usually cautious words of the Bank of England, raised a “material risk” of a breakdown in financial stability, coming close to a “fire sale dynamic”. The interest rate, or yield, on British government borrowing has shot up with almost unprecedented speed. The move in September was the largest monthly increase in any major economy since at least 1987. That was enough to force the Bank to intervene in an attempt to restore a sense of orderliness in an operation that is due to end on Friday 14 October.
The immediate consequence has been mortgage rates on new loans jumping to their highest level in more than a decade and half. As mortgages reset from lower priced, fixed-rate deals, consumer spending will take a serious hit. In the longer run, higher yields on gilts will make the cost of servicing Britain’s government debt higher, which means that more of the tax take will be diverted away from spending on public services and towards debt interest payments. It will increase borrowing costs for firms, slowing down their investment and hiring plans.
In short, this is all deeply unpleasant for an economy that already looked to be sliding into recession.
This year was already proving tough for bond markets well before Liz Truss became prime minister. The lingering impacts of the pandemic on supply chains, coupled with a sharp rise in global energy prices following Russia’s invasion of Ukraine, had already pushed inflation to the highest levels seen since the 1980s. To bring inflation down, central banks have been raising interest rates to slow economic demand and to attempt to relieve some price pressures. The Bank of England had raised interest rates from just 0.1% last December to 2.25% on the eve of the mini-budget.
Rising short term interest rates – and expectations that they will rise higher in the future – make government bonds less attractive to investors. Why buy a 10-year gilt with a yield of, say, 2% today if you expect to be able to pick one up with a yield of 3% in a few months’ time? As expectations of interest rates change, so too do bond prices.
Investors reacted to Kwarteng’s plan for growth by dumping gilts. Taken together, the energy price intervention and the £45bn or so of unfunded annual tax cuts would, they assumed, add to economic demand and hence increase price pressures. That would force the Bank to raise interest rates even higher in the future, and that made holding gilts less attractive.
The government may have lit a fire in the gilt market with its sudden shift away from fiscal conservatism, but it turns out that that market was already covered with combustible material. As has become apparent over the past few weeks, many large pension funds operating in the market for longer term government debt had employed a great deal of borrowing and pledged their gilt holdings as collateral for those loans. As prices moved at an unexpectedly quick pace, they found themselves subject to calls to make immediate payments. What followed was a doom loop: falling gilt prices forced some investors to sell gilts to raise cash, putting further downward pressure on prices and risking more selling. This is the fire sale dynamic the Bank stepped in to prevent.
This brings us to the curious, and in some ways unprecedented, situation that Britain’s central bank has found itself in during the past fortnight. Since 28 September the Bank has stood ready to buy gilts each day in order to prevent a dysfunctional market. But it has also insisted that its role as firefighter is a strictly temporary one. Andrew Bailey, the governor, warned on Tuesday evening that pension funds had only three days remaining to get their house in order.
What’s going on in Threadneedle Street? The Bank’s fear is that actions intended to prevent a complete breakdown in the gilt market are perceived to be simply cleaning up the government’s mess. The dread for central banks is to be seen as subject to “fiscal dominance” and reduced to a subservient role supporting the finance ministry. The longer the Bank’s interventions in the gilt market continue, the greater the risk that it is seen as having given up on its job of controlling inflation and instead concentrated on helping the government to meet its funding costs. A loss of credibility on the inflation front could cause inflation to run even higher. If wage-setters, firms and markets believe the Bank will not act to reduce inflation, then they will act accordingly.
Still, despite the Bank’s very vocal insistence that this particular intervention will end on Friday, it is incredible to warn of the risk of a fire sale on Tuesday and yet act as if everything will be sorted by the end of the week. Some form of further Bank support seems likely.
Clarity matters in a crisis, and this week the Bank has sown confusion. Andrew Bailey hit the news wires from Washington on Tuesday night with his “three days left” warning. But the next morning the Financial Times suggested senior bankers had been reassured the intervention would continue. The Bank was reduced to tweeting that Friday was still the intended end date. Looking like a reluctant firefighter might help the Bank, but looking like an incompetent one helps no one. Setting artificial deadlines that are later revised is a self-inflicted wound.
In the final analysis, while the Bank can smooth the edges of the crisis, only a change in fiscal policy from government can address the root causes. The ball is back the chancellor’s court as he prepares his medium-term fiscal plan for Halloween. We’ll have to wait and see who’s spooked this time.
Duncan Weldon is an economist and the author of Two Hundred Years of Muddling Through.
