US inflation and UK bond market could shake markets

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The pound had fallen to record lows against the US dollar and UK bond rates soared after the new Truss government announced massive but unfunded tax cuts and spending.

This announcement was made in the context of an inflation rate of almost 10% and a central bank which, in addition to aggressively raising interest rates, was about to launch a program of quantitative tightening ( allowing the stack of UK bonds it had purchased to lower rates and increase liquidity in response to the pandemic to mature without reinvesting the proceeds).

US inflation numbers could rock markets this week. Credit:Bloomberg

The sharp rise in UK interest rates as investors reacted to the fiscal frenzy sparked margin calls for the giant UK pension fund industry, which had used derivatives to hedge its liabilities and was compelled to provide more guarantees.

Much of the sector could have been insolvent had the BoE not stepped in and announced it would buy long-term bonds and create orderly access to liquidity for funds as they shed their most liquid high-quality assets – primarily their UK government bonds. , although they also sold highly rated UK corporate bonds – to raise additional collateral.

The action of the BoE and the partial volte-face of the Truss government restored some stability to the markets. The pound rose and UK bond yields fell.

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However, the bank’s intervention was always intended to be temporary. He would buy bonds for a fortnight, then focus on inflation again and start selling his bonds on October 31.

So the window for pension funds to jump in and raise the roughly £500 billion ($880 billion) of cash they need will close on Friday.

The BoE bluntly rejected their requests to extend the period during which it was a bond buyer.

BoE Governor Andrew Bailey said on Tuesday that “my message to the funds and others involved is that you have three days left now. You have to do this.

Bank of England Governor Andrew Bailey sent a stark message to pension funds earlier this week.

Bank of England Governor Andrew Bailey sent a stark message to pension funds earlier this week.Credit:Bloomberg

Unsurprisingly, it didn’t go well. The pound fell sharply again and yields on UK 30-year bonds (the most affected by the pension fund sell-off) jumped again.

When UK markets wobbled last month, they sent shockwaves through international stock, bond and currency markets, underscoring how interconnected global markets are and raising the possibility that if the BoE misjudged the situation in the UK markets, it could again inject even more volatility and instability into already volatile and unstable global markets.

The combination of a worse-than-expected US inflation rate and another round of turmoil in UK markets could be quite unpleasant.

The BoE, like the Fed and other central banks, including the Reserve Bank, is caught between a rock and a hard place. They know they are pushing their economies into recessions and generating financial market volatility, losses and potential systemic instability, but their priority is to rein in runaway inflation rates.

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Efforts by governments, like the Truss government, to mitigate the impact of monetary tightening and the acute energy crisis in the UK and Europe through looser fiscal policies will only force more drastic responses from from central banks.

However, the potential for overshoot is real.

So far this year, although the Fed has only recently begun to accelerate the pace at which it reduces its balance, central banks have reduced their holdings of bonds and other fixed-income securities by more than $3 trillion. .

Governments are also selling US Treasuries in an attempt to mitigate the impact of significant US dollar appreciation on their own economies.

The biggest bond buyers during the pandemic are therefore now on the sidelines, but there is a shortage of new buyers available to replace their demand, prompting US Treasury Secretary Janet Yellen to worry this week about the adequacy of liquidity in the US Treasury bill market. .

Some attribute the low liquidity in bond markets to the actions of central banks, made worse by post-global financial crisis regulations that limit banks’ ability to act as brokers and provide liquidity to markets.

The combination of a worse-than-expected US inflation rate and another round of turmoil in UK markets could be quite unpleasant.

Others, like famed economist Mohamed El-Erian, have spoken of the “return of bond vigilantes” after a decade of unconventional central bank monetary policies keeping them on the sidelines.

Vigilantes have historically sold bonds and/or stayed out of the market to protest monetary and/or fiscal policies that they viewed as inflationary and therefore undermining the real value of their investments.

This led to higher bond yields and lower prices (as yields rise, the market value of bonds falls) and, in effect, injected investor will into effective monetary policies.

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The current shallowness of financial markets likely reflects the combination of reduced demand from agencies and the private sector and bottlenecks in financial systems, as well as broader uncertainty about what the near future global economic future holds. term, which seems increasingly gloomy, could produce.

This is why inflation data releases, especially US data, or timelines for central bank interventions like those of the BoE, represent potential flashpoints not only for markets, economies and national financial systems, but also for global markets and economies and the global financial system.

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