By Michael Every of Rabobank
"Whatever it takes... until Friday"
I rose early today with a nagging suspicion I was going to have to focus on the BOE. How right I was! And how right everyone will be to pay attention too. What we are seeing in real time in the UK is a decades-long hyper-financialisation of the economy being partly unwound on fast-forward at gunpoint; and/or a trigger for a multi-decade market hyper-crash on fast-forward; or both. And more to boot if you extend your view wider.
The BOE had already been forced to step in again yesterday to add ‘Linkers’ (inflation-linked Gilts, which really should be doing better than non-inflation-linked ones given what inflation is doing) to the list of securities it is prepared to step in and buy. That was a dramatic intervention, following equally dramatic market movements, where 5-year Linker real yields had surged 50bp in one session – EM action in one of the world’s leading financial centres, in a G7 economy that issues its own currency. (Which is ironically part of the problem in this case.)
Yet then things got really serious (and thanks to our Gilts Meister Stefan Koopman for additional help for sleep-deprived eyes here). At an IIF event in Washington, DC, BOE Governor Bailey admitted what is plainly visible: the Bank’s interventions in the Gilts market show its monetary policy objective and its financial stability mandate are pulling in opposite directions. That is bad enough, and more so when the government’s fiscal policy and monetary policy are also pulling in opposite directions.
Bailey then stated to pension and LDI (Liability-Driven Investment) funds: “You’ve got three days left now,” to exit problematic positions. “You’ve got to get this done. The essence of financial stability is that it is temporary. It’s not prolonged.” In other words, restructure the entire industry by Friday by selling whatever is needed, then the BOE quits the “QE R US” game!
That is outright dangerous and clearly makes Gilts a target. Time-limited central bank backstops NEVER work --“Whatever it takes… until Friday”-- and the whole idea of being a lender of last resort is you will ALWAYS be there. Stefan expects a U-turn after a lot of unnecessary damage has been done – which we can presume will start today as a financial storm like the physical one that just hit Florida. So, why is the BOE doing this when it must know what is about to unfold?
Looking through a microscope, the BOE may be following the UK government ‘EM’ lead.
Looking through a telescope --and assuming Bailey has read Bagehot-- one must conclude the BOE is instead putting pressure on the government in a game of chicken, i.e., to reverse more tax cuts and be more serious about fiscal policy in general. That means the unelected independent central bank is setting fiscal policy: which may sound shocking in the UK, because it is dangerously European.
That would make sense if the BOE, like most central banks, hadn’t been prepared to buy any government debt moving --or unmoving, given nobody has traded JGBs for three sessions in a row, apparently-- until now; and if didn’t just narrowly avoid becoming a government target over creating the mess we are now in - unless the Old Lady doth now protest too much as a result.
Looking through a hypothetical macroscope, one can see several key linkages.
Why are sharp falls in the value of Gilts so dangerous to boring old UK pension funds? Yes, they have taken big losses, and they mark-to-market, yet stocks and sectors go down like that all the time, and markets get through with a ‘bad year’ and so systemic risk: ask China and Cathie Wood.
Sadly, LDI may also stand for Leveraged Dangerous Instruments: by implication, many funds are highly leveraged again (as pre-2008), and exposed to derivatives using dazzling math to pretend above-benchmark returns can be created risk-free from thin air again (as pre-2008). This always ends badly after a “whocouldanooed?” event not factored into the equation - which is usually an anyone couldanooed: “Russia can’t raise rates!” - 1998; “The US can’t raise rates!” - 2008; “The UK can’t raise rates!” - 2022. Raise your game, people!
Consider this: Bailey was presumably not speaking alone given he was in DC at the IIF, not in the pub. Perhaps the BOE is sending the united message that the game has changed, Volcker style. Because don’t for one moment think only the UK is in this particular pickle: it isn’t. Similar funds have used similar strategies all over. All will need to be unwound at some point. So, the *global* message may be that markets *must* unwind trades that are going to fail anyway as rates rise and stay high, with a brief central-bank backstop.
Then they will have to reinvest AUM and future inflows into boring old bonds yielding much more (e.g., 4.80% for the 30-year yield at time of writing: it could be 50bp higher or lower shortly). While less than half the rate of inflation now, that is still better than a guaranteed loss when an LDI strategy implodes. It also offers a way to rebuild returns again after the huge fall almost all portfolios are going to take this year. Try compounding 5% over many years, presuming inflation comes back down again. It’s not so scary; it’s just not as sexy as get-rich-quick schemes based on leverage and derivatives.
But why aren’t we just seeing less Bagehot and more Draghi “Whatever it takes” bag-holding? Because the game may really have changed globally. Wars do that. Economic wars do that, especially when commodities are being touted as alternative stories of value to fiat money flowing via QE from central banks into asset prices held mostly by the top 1% of Western society. Indeed, as I have written repeatedly of late, a financialised Western economy is not one that is capable of sustaining a war or an economic war. (And neither is one prepared to keep draining its Strategic Petroleum Reserve, entirely coincidentally around mid-term elections: the snap-back is going to be a shock to markets perhaps requiring even sharper tightening of monetary policy.)
If the BOE is playing chicken with the UK government, note the UK government is itself playing chicken with geopolitics. Reportedly, PM Truss will today designate China as a “threat” alongside Russia and North Korea: a few years ago, China was going to build British nuclear power stations. That stance is going to cost money in many sense of the term. Of course, the BOE saying that it won’t backstop government spending via QE runs counter to my MMT + rate hikes theory: but once markets have been ‘restructured’, that war-economy bridge can be crossed… or not.
Anyway, markets are going to hate what the BOE said. And? And nothing. Markets will hate it. Meanwhile, the war and economic war will roll on, and over the top of those not paying attention to what now matters most to policymakers.
There does appear to be recognition the world is changing in some corners. The Financial Times is carrying an excellent series of articles about the end of globalisation alongside the usual op-ed jazz-handsery of how this can all be effortlessly avoided. The New York Times notes ‘Biden Proposal Could Lead to Employee Status for Gig Workers’, which sounds like disruption to me. The Swiss are tapping Fed swap-lines again – a path many more will soon be following.
Even EU foreign policy chief Borrell gave a recent speech in which he noted: “…uncertainty is the rule. Events that one could imagine that they will never happen, they are happening one after the other. At this pace, the black swan will be the majority. It will not be white swans --all of them will be black-- because one after the other, things have happened that had a very low probability of happening, nevertheless they happened, and they had a strong impact and certainly they happened.
Our prosperity was based on China and Russia – energy and market… but the fact that Russia and China are no longer the ones that [they] were for our economic development will require a strong restructuring of our economy…. On the other hand, we delegated our security to the United States.”
Well done for seeing the truth ten years too late: but no sarcasm there, really, as by contrast German Chancellor Scholz is about to head off to China with a delegation of businesspeople saying he absolutely won’t decouple. Just as he won’t allow EU debt mutualisation during an economic war; or arm Ukraine much; or re-arm Germany with much urgency; or rustle up magical new energy in the short term, as the IMF warns Europe that winter 2023 will likely be far more difficult than winter 2022. Then again, who is looking to Germany for any leadership on anything right now? Nobody: and expect things to get worse on that front if it is gradually deindustrialised by soaring energy prices.
But I digress. Let’s not let the rapid implosion in EU norms eclipse the three-day window that the BOE has just unleashed with its “Whatever it takes… until Friday.”