While the prospect of a central bank-engineered global recession is focusing the minds of policymakers, it is the fragility of financial markets that may represent the greatest threat to growth — and the real concern for politicians such as Treasurer Jim Chalmers charged with plotting a safe fiscal course.
The UK financial system again nearly collapsed overnight, in the persistent fallout from the Truss-Kwarteng disaster, prompting another major intervention by the Bank of England (BOE).
The cause was another spike in bond yields for UK government debt, which blindsided markets and regulators. The BOE was forced to double its potential support buying to a massive £10 billion a day to try to correct what it said was “dysfunction” in the markets. In doing so, the bank warned — for the second time in 13 days — of “material risk to the UK’s financial stability”. It said there was “the prospect of self-reinforcing ‘fire sale’ dynamics [that] pose a material risk to UK financial stability”.
The BOE’s bond-buying program, announced after the Truss government’s disastrous fiscal package and intended to end this Friday, had initially calmed markets, and the bank was actually spending only a fraction of its self-imposed £5 billion a day buying of UK government bonds to protect UK pension funds. Suddenly it had to announce it was doubling its firepower.
The “dysfunction” was the sudden emergence of investor unwillingness to hold UK debt of any type or duration, especially UK government debt — a loss of confidence in the creditworthiness of the UK government and its financial soundness.
The immediate cause of the BOE intervention was a remarkable spike in the yield on the benchmark 30-year gilt (UK government bond), which jumped 0.317 percentage points to end at 4.697% on Monday, the highest since yields exploded after the fiscal package. With UK pension funds struggling to find buyers for the gilts they needed to sell, both pensions and the wider British credit system were in danger.
But the deeper cause is a near-complete loss of faith in the Truss government, which urgently needs to provide markets with a credible plan to rein in its debt. It was confirmation by Chancellor Kwasi Kwarteng that he was bringing forward his budget from late November to the end of this month that seemed to trigger the panic.
The problem is, any spending cuts are going to send the UK into political chaos, and Truss is wedded to tens of billions in tax cuts even after ditching those for high-income earners.
While the Truss government is spectacularly bad by any standards, the lack of market confidence in UK debt is a serious moment for the global financial system — and holds real implications for Australia.
The latest International Monetary Fund Global Financial Stability report, coincidentally out overnight, spells out some of these dangers.
“Global financial conditions have tightened notably this year, leading to capital outflows from many emerging and frontier market economies with weaker macroeconomic fundamentals. Amid heightened economic and geopolitical uncertainties, investors have aggressively pulled back from risk-taking in September. With conditions worsening in recent weeks, key gauges of systemic risk, such as higher dollar funding costs and counterparty credit spreads, have risen. There is a risk of a disorderly tightening of financial conditions that may be amplified by vulnerabilities built over the years.”
A disorderly tightening is code for a major credit crisis that seizes financial markets and brings the real economy to a quick halt because lending — for housing and for businesses, and even for governments, except at much higher rates — stops, as we came within a whisker of in 2008.
As we’ve previously noted, Australia is in a significantly better debt position than the UK — just a quarter of GDP in borrowings, not 100%. Markets have confidence in the new government of Anthony Albanese and Jim Chalmers. And by virtue of Australia being an energy exporter, our federal budget is being showered with revenue.
But when markets are this worried, and levels of trust are this low, any government other than the US is one fiscal disaster away from what has been unfolding in the UK.
A key goal of the budget in a fortnight will now be to offer a convincing fiscal story to markets that assures them Australian government debt — triple-A rated thanks to Wayne Swan more than a decade ago — remains a safe investment because policymakers have got things under control.
