The U.K. Gilts Crisis: A Harbinger of Things to Come?
In 1994, James Carville, an advisor to U.S. President Bill Clinton, stated he’d like to be reincarnated as the bond market because “you can intimidate everybody.” The U.K. gilts crisis has intimidated with a vengeance. Corporate Finance columnist Les Nemethy looks at what this might indicate.
As Former U.S. Treasury Head Larry Summers famously recently stated: the “U.K. is behaving a bit like an emerging market turning itself into a submerging market.” In 18 months, 30 year Government Bond (gilt) yields have quadrupled, with most of the acceleration happening over the past six months:
You might argue that the United Kingdom is a particular case. Brexit caused a loss of trade markets, accelerated London’s decline as a financial center, destroyed investment and confidence, and took the country to the edge of a precipice. Liz Truss’ weeks-old government pushed it over the edge with a very ill-advised budget.
An optimist might say this is a “one-off” crisis with little chance of occurring elsewhere. In this article, I will first talk about recent global developments and then provide a brief analysis of why, in my opinion, the U.K. gilts crisis may be a harbinger of things to come.
Some of the recent messages coming from major national and international institutions have shown both inconsistency and a rapid deterioration in outlook.
Oct. 7. The European Central Bank warns of a “potential wave of default on banks.”
Oct. 11. The International Monetary Fund says there is an “increased risk of rapid, disorderly repricing in financial markets […] exacerbated by existing vulnerabilities and a lack of liquidity.”
Oct. 11. The IMF says, “In a severe economic downturn, up to 29% of emerging market banks would be undercapitalized.”
Oct. 11. U.S. Secretary of the Treasury Janet Yellen seems confident: “I’m not seeing anything in markets that causes me to be concerned.”
Oct. 12. One day later, Secretary Yellen appears to have spotted something after all. “I’m concerned about the loss of adequate liquidity in Treasuries.”
It is remarkable that Yellen would make such a strongly optimistic statement on the same day as the IMF issues a very negative picture, only to flip-flop the next day. That goes to credibility.
Perfect Storm Building
The upcoming perfect storm that is brewing stems from the confluence of many inter-related factors:
1. record global debt levels;
2. stubbornly high global inflation;
3. supply side constraints (particularly in the area of energy, compounded by serious policy errors);
4. profound macro shocks (COVID-19, the war in Ukraine);
5. the steepest rate hike over any four months in the history of the Fed (against the background of weakening economic performance), and
6. the simultaneously dismal performance of both equity and bond markets.
The world has, in the past, had to deal with a few of these at a time, but never with all at once. Despite global markets being increasingly integrated, there is no evidence of coordination between the central banks. Because of high inflation and tight job markets, the U.S. Fed may continue tightening, at least a few hundred more basis points.
The following chart shows that since the Great Depression, there have been only three years, including 2022 year-to-date, where both equities and bonds had negative returns:
Furthermore, the first three quarters of 2022 have given the worst performance of any comparable period for bonds, as well as for a 60/40 portfolio of equity and bonds, in the past century; worse, even, than during the Great Depression.
Now, to come back full circle to the U.K. gilts crisis: the main reason the Bank of England had to suddenly change gear from Quantitative Tightening (QT) to Quantitative Easing (QE) was to save the U.K. pension industry, which risked being completely wiped out by the sudden spike in yields.
Pension funds must make fixed payments on so-called defined benefit pensions. Given the low-yield environment since 2008, they have shifted into ever-riskier investments to generate sufficient yield to service payments.
Given the recent quadrupling of yields, bond prices have come tumbling down. Not only do lower bond prices make it more difficult for pension funds to make payments, which goes to solvency, but they must also maintain regulatory liquidity ratios, which forces sudden liquidation of assets, driving bond prices further down and creating a vicious circle.
Hence, the Bank of England suddenly needed to reverse from QT to QE to prevent an entire generation of pensioners from being wiped out financially.
These issues are not unique to Britain. The largest pension industry in the world is in the United States (USD34 trillion), which is experiencing similar, albeit for the time being less drastic, liquidity issues to the United Kingdom.
Yields are expected to continue to surge, which would drive bonds and equities lower, potentially creating a U.K.-type scenario. Could the pension industry become the Achilles heel of the U.S. economy, similar to mortgage-backed securities in 2008-2009?
Allowing pensioners to become financially wiped out is something no government can politically afford.
Les Nemethy is CEO of Euro-Phoenix Financial Advisers Ltd. (www.europhoenix.com), a Central European corporate finance firm. He is a former World Banker, author of Business Exit Planning (www.businessexitplanningbook.com), and a previous president of the American Chamber of Commerce in Hungary.
This article was first published in the Budapest Business Journal print issue of October 21, 2022.
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