Tatton News Archive

Latest News from Tatton Investment Management: Change in the air

14 October 2022, 12:00am

It is not often that market action in the UK capital market moves the global capital market dial, given our domestic stock market comprises just 3.1% of the global total and 4.1% of the global total government bond market. However, over the course of October, far bigger bond markets – like that of the US and Italy – have experienced significant changes in the wake of what happened earlier in the day in the UK.

We write about the vagaries of the UK’s government bond market and its consequences in an article below entitled “Gilt Trip” – and not all of them bad. The current government has been much-derided for suggesting that its issues are all a direct result of circumstances elsewhere and there is little doubt that its members took a remarkably cavalier approach in making policy. They have found it difficult to own up to their mistakes, although clearly that appears to be changing somewhat as we write.

However, Prime Minister Liz Truss does have a point – except she may have been under a misconception on the UK’s fiscal wiggle room relative to the US. Russia’s invasion of Ukraine has destabilised Europe’s energy markets which has forced all of Europe (including the UK) to expand near-term fiscal deficits again. Most importantly, (and perhaps indirectly caused by Europe’s stress) the relative insulation from the rest of the world’s problems enjoyed by the US has pushed risk-averse global capital towards the safe haven of the US dollar.

The US economy has had a series of tremendous boosts to its ability to attract capital, starting with for President Trump’s corporation tax-cutting policies designed to bring capital home to support blue collar jobs. Then the pandemic caused yet further challenges of supply security, with the Biden administration effectively subsidising large amounts of investment, for example to re-shore micro-chip production.

The US Federal Reserve (Fed) has abetted this, although it cannot be blamed for doing so. Thus, the US dollar has motored ahead, and interest rates and bond yields have risen in parallel to expanding economic activity. In particular, the sharp rise in yields on US inflation-linked bonds has been at the heart of the stresses in the global economy.

One can think of the rest of the world as facing a massive competition for capital. In that environment, it might seem strange for the UK government to make a policy choice to try to grab more capital at a point when the costs have been made almost unbearable. To blame circumstances now suggests Truss et al. were unaware of the situation when devising the policies. It’s no wonder the Chancellor of the Exchequer is now a different person.

Global markets have been cheered by signs that the UK is unwinding its policy choices, lessening the fight for capital. Indeed, should the government reverse the bulk of policies that capital markets balked at as fiscally irresponsible, then rates and yields may revert to the trajectory they were on before September’s fateful fiscal event. Whether they will fully will largely depend on how much of the trust in UK institutions lost by international investors can be regained. This week saw Andrew Bailey, governor of the Bank of England, losing his much-needed cool with both the pension fund industry and the UK government for their apparent inability to grasp the urgency of the situation. But perhaps this episode may in the end help to re-establish trust in the UK’s institutions rather than being remembered as a major central bank gaffe as most commentators interpreted it. Next week will undoubtedly give us more to ponder over.

From the global perspective, beyond the UK’s domestic woes, the October 2022 UK bond market crisis will be remembered as the moment when central banks around the world were forced to grapple with something they have been denying for many months. Namely that their formidable efforts in forcing the inflation genie back into the bottle have unveiled fragilities in the global financial markets that may now hamper their ability to follow through with their inflation fighting strategy. The dependencies on ultra-low interest rates they had allowed to build up since the Global Financial Crisis mean that the risk that something, somewhere in the global financial ecosystem would break – or at least seriously buckle – has now become apparent.

In the case of the UK, the damage may have been limited by the reversal of political miscalculations. However, it is not hard to imagine other scenarios where central banks may have to intervene more substantially to prevent their inflation fighting efforts not just causing a mild recession, but a far deeper credit default cycle than currently anticipated. This week’s ‘Fed speak’ comments by central bankers told us they have got the message, and in the US, Thursday’s biggest daily turnaround stock market rally since 2020, despite hot inflation and implied rate rise news, tells us that equity investors likewise believe central banks have just lost the worst of their biting strength in their fight against inflation. It seems their own past profligacy has just caught up with them and that attempting to turn the bond yield ‘tanker’ around may well require gentler steering from here.