London Calling

Research Oct 19, 2022

Key Take-aways

·      Gilts, as if jealous of all the attention crypto markets received over the summer, have had a “hold my beer” moment. A 130bp roundtrip in less than a fortnight is not the sort of move one expects to see in developed government bond markets.

·      Forced by the need to ensure financial stability the BoE intervened in the gilt market, but the intervention was limited in scale and time.

·      The impression many investors have been left with is that UK policymaking is being done on-the-fly, the optics of which are never good from a credibility perspective.

·      Many crypto commentators saw the BoE’s actions as QE resumed. This is wrong. Neither is yield curve control just around the corner in the UK. Anyone tempted to buy crypto for either of these reasons is likely to find themselves disappointed.

·      While the short-term dynamics for crypto remain challenging – especially as the recent hotter-than-expected US CPI print did nothing to boost Fed pivot hopes - there are some clinks of light beginning to appear.

·      Monetary and fiscal policies are on a collision course, not just in the UK but in many other developed economies. The unprecedented repricing of UK government bonds demonstrates as much because it shows increasing investor sensitivity to fiscal sustainability. What we are witnessing is the opening salvos of this clash.

·      There are no easy solutions or silver bullets available to policymakers to rectify the situation. Indeed, whatever option they choose the omens look good for crypto.

·      One canary in the coal mine will be Japan – a country whose bond market is even more dysfunctional than the UK (as incredible as that sounds) and whose currency is on already on the skids.

In my last research note which looked at Fed policy and its economic, financial and crypto impacts, I touched - in passing - on the tension that had surfaced within the UK government bond market. Tension is really an understatement because the BoE’s “temporary and targeted” interventions first announced on September 28 were made in response to what the bank has subsequently described as “an unprecedented repricing in UK assets”. It’s as if Gilts, jealous of all the attention crypto markets received over the summer, had a “hold my beer”[1] moment.

On the BoE announcement, and for a few days after, the central bank’s actions seemed to have worked. Gilt yields screamed lower and during the first eight daily auctions they ended up buying only £5bn worth of gilts, equating to 12.5% of the potential size of the intervention. It looked like the power of verbal intervention was sufficient to calm things down, mitigating the need for actual intervention. Happy days! … or not.

As I noted at the time, if a week is a long-time in politics it is an eternity in financial markets. With the October 14 deadline for the BoE’s “temporary” intervention starting to loom large and still no word from the government as to how the UK public finances would be put on a sustainable trajectory, gilt yields resumed their upward march. In fact, at one stage 30-year gilts were trading back to levels where the BoE announced its intervention – see chart.

A 130bp roundtrip in less than a fortnight is not the sort of move one expects to see in developed government bond markets.

UK 30-year Government Bond Yields

Source: tradingview.com

On-The-Fly

The ad hoc (I’m being polite) manner in which UK policy announcements have been made over recent days has certainly been unsettling. The Chancellor’s economic plan, supposed to be published on November 23, was hastily brought forward to October 31. Worse, a week later he was gone, sacked after just 38 days in the job. In addition, UK PM Liz Truss U-turned on her commitments not to hike the corporate tax rate and to cut the top rate of income tax, leaving the economic plan she was elected to implement just several weeks prior looking decidedly threadbare.

Separately, the BoE issued a series of announcements – see below – altering its intervention programme. It beefed up the size of the daily auctions (it was doubled to £10bn) and extended them to include index-linked gilts as well as adding a new collateral repo facility, which interestingly runs beyond the October 14 deadline.

Recent BoE Announcements

October 10: Temporary Expanded Collateral Repo Facility - Market Notice[2]

October 10: Bank of England announces additional measures to support market functioning[3]

October 11: Temporary Purchases of Index-linked Gilts – Market Notice[4]

The impression many investors have been left with is that UK policymaking is being done on-the-fly, the optics of which are never good from a credibility perspective. At the time of writing, it is even unclear whether the damage to Liz Truss’ reputation means she still commands the respect of her party and hence will be able to stay on as PM. If not, her stay in 10 Downing Street could turn out to be the shortest in UK history.

Events, My Dear Boy, Events[5]

Amid all the confusion and uncertainty, one thing is clear. The BoE found itself in a position it did not want to be in. Interventions were required to safeguard against potential financial instability arising from the toxic effect the back-up in gilt yields was having on the UK pension fund industry. That this was the target audience is clear not just because the BoE told us so[6], but because they extended eligible assets to include linkers – index-linked gilts – the largest holders of which are UK pension funds[7]. Ensuring financial stability is the number one objective of any central bank bar none – and that includes, if needs be, the price stability mandate. Faced with a potential death-spiral in the gilt market, the BoE had absolutely no choice but to step in. It was forced, by events, to act.

Tightening With A Twist

Much has been made of the conflict between the BoE adding unsterilized liquidity at the long-end of the gilt curve via its interventions (stimulative) whilst simultaneously raising short-term interest rates (contractionary). The worry being that this clash between monetary policy and financial stability objectives would impinge upon the BoE’s ability to achieve its price stability mandate and, even more troubling, raise doubts about its operational independence[8].

QT (quantitative tightening) was one of the policy tools the bank intended to deploy to reinforce the impact of its rate hikes. In fact, the QT programme was due to start just a day or two after they were forced to intervene, a highly ironic – and embarrassing - volte face. Clearly QT now is off the table, potentially for quite some time. Nevertheless, in my view, these worries are/were overstated.

Central banks are more than capable of conducting monetary operations that target different sectors of the yield curve in different ways whilst complying with their price stability mandates. Indeed, there is precedent. In 1961 the Fed conducted Operation Twist whereby it sold short-term Treasuries to boost short-term interest rates in order to defend against gold outflows (the USD was on the gold standard at the time) while simultaneously buying longer-dated government bonds to nudge[9] long-term rates down to offset any contractionary effects.  The Bernanke Fed deployed a similar tactic in the aftermath of the Great Recession[10]. The only real difference between these two instances and the situation the BoE finds itself in today is the motivation for buying the long-end of the curve.

Different Strokes

The BoE has been extremely careful to differentiate its recent gilt purchases from its earlier QE programmes (although not everyone seems to have got the memo[11]). The aim of the earlier QE programmes was to stimulate the economy when there was no further room for manoeuvre on short-term interest rates due to the constraint of the zero bound. This is very different from the current situation. The BoE has been buying gilts for non-monetary policy reasons and there is plenty of room for manoeuvre on short-term interest rates when they are rising because there is no upper bound. If anything, the pace of short-term interest rate hikes looks set to accelerate. Speaking after the interventions began, BoE chief economist Huw Pill, indicated that a fairly sizeable interest rate hike will be forthcoming at the next MPC meeting in early November because a “significant” monetary policy action is required[12].

Furthermore, although the BoE had absolutely no choice but to step in and short-circuit the death-loop dynamics that surfaced in the gilt market, there was no reason for the interventions to be done on overly generous terms and they weren’t. The BoE auctions were conducted at yields fairly close to the levels trading in the secondary market. Offers that were deemed sufficiently far away – ie at much lower yields – were rejected even if it meant the auction was below the maximum allocated size. This is why the take-up was so modest, at least initially. The risk of disorderly market conditions was removed, but the underlying upward pressure on yields was not.

Part of the reason for conducting the interventions in this manner was to avoid the perils of moral hazard[13]. The other part was the bank deploying some good old game theory and playing chicken with the new government. Injecting debt-financed fiscal stimulus at a time when the central bank is tightening monetary policy to correct a significant inflation overshoot was not the wisest course of action and clearly Bailey and his BoE colleagues were not fans of the Truss fiscal plan. By failing to alleviate the upward pressure on gilt yields, and offering up only a two-week window for interventions, the BoE kept the pressure on the government to rethink its plans. Certainly, for an industry shaped by a multi-decade long bond bull-market and that had accumulated assets totalling £1.6tr (70% of UK nominal GDP) in return-enhancing – read leveraged - LDI strategies, two weeks looked untenable.

Unsurprisingly, therefore, as the deadline approached speculation mounted that the BoE would be forced to extend beyond October 14th. Rather than capitulate, BoE Governor Bailey doubled down insisting that the central bank “will be out [of the gilt market] by the end of the week” adding you have “three days to get this done”[14]. These were strong words. Given BoE purchases of gilts doubled to £4.6bn gilts at the next day’s auction, increasing to £4.8bn the following day, it is clear at least some pension funds got the message.

Adopting such a strong position was a risky strategy for the obvious reason that the bank’s commitment to end the intervention was not really credible. Financial instability worries had already forced the BoE buy gilts, if the government had stuck with its original plans, they would have been forced to buy again no matter what Bailey said. To not do so would have a gross dereliction of duty and probably cost Bailey his job.

That said, judged by the policy U-turns and change of personnel in 11 Downing Street – both announced on the last day of the BoE’s two week intervention window (quelle surprise) - the risk paid off. As things stand the current score card reads:

BoE: 1 - Truss Government: 0

Crypto Consequences

The BoE’s facing down of the UK government has importance implications not just for traditional financial markets but also for crypto, both in the short-term and the long-term.

Many crypto commentators saw the BoE’s actions as QE resumed. For the reasons I have already discussed, this is wrong. This is not QE resumed. Neither is yield curve control just around the corner in the UK. Anyone tempted to buy crypto for either of these reasons is likely to find themselves disappointed.

The BoE remains in control of the monetary reins and it will continue to pursue its rate hiking cycle until it is confident the inflation genie is back in the bottle. We are not yet at that point. This holds even if the BoE is forced to resume its gilt interventions beyond October 14, which I think there is a fairly good chance of happening because I concur with the view that it is nigh impossible for an industry of the size of UK pension fund industry to have rebalanced their portfolios and hedged out interest rate risk given the timescale and the sums involved. I am sure I am not alone in this view, the bond vigilantes will be all too aware of it too.

The longer-run impacts are, however, more encouraging for crypto. The one thing this recent episode demonstrates is something I noted in an earlier research note[15]. To wit,

“when debt-to-GDP ratios are low the spillovers from monetary policy to fiscal policy are limited and central banks are largely unencumbered in achieving their price stability (low inflation) objective. When debt-to-GDP are high and rising, these spillovers are considerably greater and sometimes monetary and fiscal policy objectives (debt sustainability) clash.”

The BoE used the considerable spillovers from monetary to fiscal policy to force a new government lacking experience to scrap key elements of its fiscal plan. Bailey’s risky strategy paid off (he buffed and Truss folded), but it won’t be that way for much longer.

The (Real) Clash[16]

Monetary and fiscal policies are on a collision course. Raising interest rates to bring down inflation will not just cause isolated problems with specific industries, like the UK pension sector, because the entire global economy has been shaped by a 40 year long downtrend in interest rates. Transitioning to a more normal interest rate environment will be bumpy – as I noted in the previous article a global downturn is not such a brave call these days. Crucially, the combination of higher interest rates and low (negative?) GDP growth will serve to push government debt/GDP ratios further into unchartered territory.

Central banks might be able to bluff inexperienced governments seeking to goose economic growth with fiscal stimulus into changing course, but governments requiring central bank compliance to help sustain historically high debt loads is an entirely different matter. They will be forced to capitulate. Not only would failure to act equate to committing the cardinal sin of breaching their financial instability mandate, but they will find out that independence, which is in the gift of the fiscal authority ie, the government, is not really independence. If the conditions warrant it, their independence will be taken away. At that point, fiscal dominance will be overt and this is a very bullish scenario for crypto prices because the result will be sustained negative real interest rates and higher inflation.

Land Of The Falling Currency

We are not yet at that point, but we are quickly approaching it. Bond sell-offs like the just seen in the UK are extremely unusual and are a clear demonstration of how fixed income investors have become increasingly sensitive about debt sustainability.

One canary in the coal mine will be Japan, because if you want to see a dysfunctional bond market take a look at JGBs[17]. The yield on its benchmark 10-year bond was unchanged at 0.25% for the past week. Sounds impressive right, given all the shenanigans going on in other government debt markets? The reason why it has been so stable is that for four consecutive days the bond didn’t trade. Not a single trade, globally, in the benchmark issue of the largest government bond market in the world. That is simply incredible!

The lack of trading activity is due to the fact the BoJ has been capping JGB yields in the secondary market as part of its yield curve control (YCC) policy initiated back in 2016. Against the global backdrop of rising interest rates JGB yields have been pushed up hard against the BoJ cap. With no room for prices to move in either direction, there is almost no incentive for investors to trade.

This policy was instigated to overcome the deflationary forces that have plagued the economy for decades. However, Japanese CPI inflation is now running at 3% headline and 2.5% core. With the inflationary impulse from the 20+% slump in the JPY still to wash through, it is becoming increasingly hard to justify. But when the government has a debt-to-GDP ratio at an eye-watering 230% of GDP, raising interest rates even a modest amount generates significant fiscal impacts, ie a 50bp rise adds more than a percentage point to the annual budget deficit, something the Japanese government can ill afford. The BoJ really is between a rock and a hard place. How Japanese gets out of its dire economic situation without resorting to massive inflation / currency devaluation[18] is beyond me.

Benign Outcomes

The only way fiscal dominance can be avoided is via sustained and significant fiscal consolidation across almost all the major economies simultaneously. This is a tough ask. Spending cuts on their own will be insufficient, not only because of the size of current government debt loads, but look what is coming down the pipe as a result of ageing of populations in the developed world – see chart.

Population Size By Labour Cohort – Upper-Middle Income countries

Source: UN Population Division (via ourworldindate.org)

Older populations means increased pension fund liabilities (many countries run unfunded pension systems, meaning the tax burden falls on future generations) and higher healthcare costs. The numbers involved are not insignificant as can be seen in the following chart, which shows stylized debt trajectories for the OECD as a whole, including and excluding the cost of ageing[19].

OECD Fiscal Projections (% GDP)

Source: OECD

Bear in mind this is the OECD, not an organization known for engaging in hyperbole.  The sums involved are mind-boggling. Furthermore, cutting these types of government expenditures is politically very difficult because people have a very strong sense of entitlement with regards to public pensions having worked all of their lives paying into the tax system, and not providing healthcare to old-age pensioners is hardly a good look for any government, certainly not one seeking to stay in power.

Most of the time these unfunded liabilities get ignored by investors. But, in a world where investors are becoming increasing worried about debt sustainability they will start gaining more attention.

Taxing Times Ahead

If spending cuts aren’t going to be sufficient on their own – and leaving aside the old structural reform chestnut[20] – then the only alternative option is increased taxes. However, there is a limit as to how much taxes governments can raise. This is what underpins the famous Laffer Curve, which defines the relationship between the tax rate and government tax revenue. It is humped shape because while increasing tax rates when they are low generates additional tax revenue, past a certain point the relationship flips negative as tax payers either increase tax avoidance measures or are discouraged from doing additional taxable work. Importantly, the peak of the Laffer Curve is not determined by the government, it is determined by societal preferences.

The time-honoured method of avoiding tax is to pay for things in truly anonymous money, namely bank notes or cash. Obviously, governments are wise to this and over recent years they have been steadily increasing restrictions and reporting requirements for high value cash transactions[21]. Many countries have set limits on the extent of cash transactions, and its why in 2018, the ECB stopped issuing the EUR 500 note (it was nicknamed the “bin laden” a pretty clear hint as to what it was being used for).

As I have noted in a previous research note[22], numerous central banks are actively exploring introducing their own digital currencies (CBDCs) that will for most intents-and-purposes displace bank notes. Their introduction will give governments the potential to have near-perfect oversight of all financial transactions, greatly increasing their ability to ensure that financial activity does not go below the tax radar.

In effect, CBDCs will shift the right hand slope of the Laffer curve outwards (although it will still be downward sloping because the discouraging effect on economic activity from onerous tax rates remains and because people can always engage in barter which is much harder to thwart) – see chart.

Laffer Curve – The CBDC Effect

Source: wikipedia and author

For a government needing to secure a larger share of the economic pie in order to remain solvent, this is a rather attractive characteristic of CBDCs and is another reason why I fully expect them to be widely introduced over the next several years.

As stated though, the optimal tax rate defined by the Laffer Curve is not set by the government. Society decides what it is, albeit in a decentralized and uncoordinated way. In a world where CBDCs replace cash, and the public’s tried and tested means of escaping an onerous tax burden is removed – or severely restricted – are they likely to just cave in? Not when they have the means to conduct financial transactions securely and beyond the eyes of the government using an unbannable form of digital money like Bitcoin, Ethereum or other private cryptocurrencies. It is far more likely, in my view, crypto usage goes up under such circumstances[23]. And, rising crypto adoption is bullish for prices due to network effects.

The Long And The Short

After the crushing effects of the crypto winter, there seems to be a real desire in crypto circles to find something positive to say. The recent turmoil in the UK gilt market was seen by some as presenting such an opportunity. Understandable perhaps, but much of the commentary contains flaws. The BoE response was not QE resumed, as widely stated, nor was has the starting pistol being fired for the next leg-up in crypto prices in anticipation of the imminent yield curve control[24]. Rather it was a central bank still engaged in the battle to bring down inflation facing down a government that had announced an ill-conceived plan to inject fiscal stimulus.

While this means the short-term dynamics for crypto remain challenging – especially as the recent hotter-than-expected US CPI print did nothing to boost Fed pivot hopes - there are some clinks of light beginning to appear.

From a longer-term perspective, it is clear monetary and fiscal policies are on a collision course, not just in the UK but in many other developed economies. The unprecedented repricing of UK government bonds demonstrates as much, because it shows an increasing investor sensitivity to fiscal sustainability. What we are witnessing is the opening salvos of this clash.

For global policymakers, there are no easy solutions or silver bullets to rectify things. Either fiscal dominance becomes explicit and the goal of monetary policy pivots from price stability to debt sustainability (result: sustained higher inflation and negative real interest rates) or governments grasp the fiscal nettle and announce sustained fiscal consolidation programmes (result: significantly higher taxes as cutting public spending to the required degree will be hard to achieve in the face of ageing populations). Whichever path is chosen, the future omens for crypto look good.

Until next time.

Ryan Shea, Crypto economist


Footnotes

[1]    See: https://www.dictionary.com/e/slang/hold-my-beer/

[2]    See: https://www.bankofengland.co.uk/markets/market-notices/2022/october/temporary-expanded-collateral-repo-facility-market-notice-10-october-2022

[3]    See: https://www.bankofengland.co.uk/news/2022/october/bank-of-england-announces-additional-measures-to-support-market-functioning

[4]    See: https://www.bankofengland.co.uk/markets/market-notices/2022/october/temporary-purchases-of-index-linked-gilts-market-notice-11-october-2022

[5]    A well-known quote by British PM Harold Macmillan in response to the question what was the greatest challenge for a statesman – see: https://www.gov.uk/government/speeches/events-dear-boy-managing-incidents-before-they-become-crises

[6]    See: https://news.sky.com/story/bank-of-england-confirms-it-took-action-to-stabilise-pensions-market-after-chancellors-tax-cutting-mini-budget-12713520

[7]    The BoE did not purchase “linkers” during its previous QE operations.

[8]    See: https://www.ft.com/content/75d0e0d9-6bdf-4509-910f-60adc4a3ccf4

[9]    The operation was originally called Operation Nudge but due to the popularity of Chubby Checker’s famous song at the time it was renamed – see: https://www.richmondfed.org/publications/research/econ_focus/2012/q4/jargon_alert

[10]  The program ran between 2011-12 and was formally known as the Maturity Extension Program – see: https://www.newyorkfed.org/markets/programs-archive/large-scale-asset-purchases

[11]  See: https://twitter.com/RichardJMurphy/status/1575068175678701568 and (unfortunately)  https://twitter.com/BitcoinMagazine/status/1575074561833705473

[12]  See: https://www.bankofengland.co.uk/speech/2022/october/huw-pill-in-conversation-with-scdi

[13]  The BoE, along with many other leading central banks were widely criticized for bailing out the banks during the Great Recession  - see: https://en.wikipedia.org/wiki/Moral_hazard

[14]  See: https://www.ft.com/content/87a5b7bf-6786-427f-89d6-96b736dcb814

[15]  See: https://blog.trakx.io/fed-fears/

[16]  Get the title now?

[17]  JGB = Japanese government bond.

[18]  The BoJ already tried to intervene to stop the JPY depreciation. It’s efforts have so far failed with the currency recently dropping to it’s lowest level versus the USD in over 30 years.

[19]  The charts are taken from an OECD Economic Policy Paper – see: https://www.oecd.org/economy/growth/scenarios-for-the-world-economy-to-2060.htm

[20]  I discussed this topic in an earlier research note – see: https://blog.trakx.io/fed-fears/

[21]  See: https://www.hks.harvard.edu/sites/default/files/centers/mrcbg/files/80_limiting.cash.pdf

[22]  See: https://blog.trakx.io/cbdcs-crypto-killers-1/

[23]  To be clear I am not advocating for private cryptocurrencies to be used for tax avoidance or any other illegal activity. I am simply stating what I expect would be the impact of governments aggressively raising taxes for fiscal stability reasons in an environment where cash usage is low.

[24]  That said, I do agree the BoE’s actions are the slippery slope to yield curve control, just not imminently.

Carole Laizet

Senior marketing manager with 15+ years of experience in the Financial Industry (traditional Banking as well as Crypto Assets). Responsible for market research @trakx.io