Liz Truss came off to the worst possible start as Prime Minister. First, she became the last person to shake the hand of the late Queen Elisabeth and, after two weeks of national mourning, politics returned with her Chancellor delivering a so-called mini budget, where billions of Pounds of spending on energy subsidies were accompanied by tax cuts and no talk of spending cuts.
In the wake of the announcement, the then Britain suffered what has been widely described as an economic crash: the Pound Sterling ‘crashed’ and so did the Gilt (government bond) market. The recklessness of unfunded tax cuts broke the trust in the UK economy – that’s the story the British and international press unanimously tell. But is that true?
Let’s look at the currency markets. It is certainly true that the GBP sold off versus the USD to a low not seen since the mid ‘80s. But though the budget induced drop in the GBP did indeed spark this headline inspiring move, the real story is not one of unique GBP weakness but of long-term USD strength. The DXY Index, a trade weighted index of USD versus other currencies, trades at highs not seen for 20 years. Indeed, versus the EUR, the GBP move was not particularly dramatic and the currency quickly recovered to trade at levels similar to before the budget. Not that you would know it if you followed mainstream media, which for days and days continued their GBP crash narrative.
What about the Gilt market? There is no doubt that the spectre of larger government deficits weighs on any sovereign debt market and the Gilt market sold off dramatically immediately after the budget. The damage would have been far worse had the Bank of England not abandoned its monetary tightening stance to embark on what essentially amounts to a new QE programme to underwrite the Gilt market. But the UK debt burden is currently the 2nd lowest in the G7, a club that admittedly includes highly indebted economies like Italy and Japan. Why did the markets react to violently?
The structure of the UK pensions market has a story to tell. Whereas the current standard pension is a defined contribution model, where the amount available to a contributor at retirement depends on the amount contributed and how the pensions manager performed in investing the funds over time, a substantial part of current pensions savings are the so-called final salary schemes, a now abandoned product where the pension paid out is not dependent on the investment performance but consists of fixed payments based on some percentage of the salary the contributor earned at retirement. This means that a large part of the liability side of a pension fund’s balance sheet is fixed, whereas the asset side, the investment portfolio, is still dependent on investment performance. This may not be a problem if investments can be found which matched the promised pension payments but presents a huge problem when central banks for years have held interest rates at zero. The solution has been leverage: instead of just investing the pension savings, the funds borrowed money to buy more Gilts than they had the money to invest in, allowing the pension funds to ‘ride’ the yield curve by borrowing money for short term interest rates near zero and picking up a small return by buying longer maturity Gilts. The lower the return on the Gilts, the more times the funds had to do this to match their assets with their liabilities. This can be done via the repo market, where the fund borrows money, buys gilts and posts those as collateral for the loans but much was done via so-called Liability Driven Investments, a product offered by asset managers which uses derivatives to replicate the return of a funded Gilt investment (a so-called Total Return Swap).
As Gilt yields spiked after the budget, many pension funds saw the value of their leveraged investment portfolios tumble. But worse, as their derivatives contracts moved out-of-the-money, they faced calls to post more collateral and were forced to sell assets to raise cash. The Gilt market didn’t just face a worsening fiscal outlook, it faced a fire sale. The result was a far more dramatic move than would otherwise have been the case.
So, how much of this mess is the responsibility of the Truss government and how much is even true? Undoubtedly, a large fiscal expansion in the face of a recession is reckless, but it has been the standard response by Keynesian governments across the globe for decades and countries (like Germany) who have resisted have often been chastised for it. Could the government have foreseen the reaction in the FX market? Maybe, but as we described above, it was neither dramatic nor consequential in any way. Of course, the government should have known about the potential of large-scale spending increases and tax cuts to undermine the trust in the credit worthiness of the country and they should also make an attempt to understand the nature of the Gilt market and the unique drivers which could cause the market to react like it did. Ignorance is no excuse when you are running the country.
But an equally relevant question is if the mainstream press should not have done a better job? Not every journalist will understand the arcane idiosyncrasies of the British pensions market and the use of derivatives by pension funds who went looking for yield in a world of rock-bottom interest rates. But looking at a chart of GBP versus EUR is surely not beyond financial journalists who want to relay stories from the global FX markets. It is, however, both easier and generates more hits to run with a narrative of the current government’s incompetence.
The conclusion to all this is – unsurprisingly – one we already knew. Yes, government is incompetent. And so is the press.