In conversations with investors about the stunning scenes in UK debt and currency markets since the government’s “mini” Budget, two names keep cropping up.
One is Warren Buffett. As far as we know, the 92-year-old “sage of Omaha”, chief executive of Berkshire Hathaway, did not have a direct hand in chancellor Kwasi Kwarteng’s big reveal of unfunded tax cuts and supercharged borrowing from the bond markets.
But Buffett’s observation — one of the most famous in finance — that “only when the tide goes out do you discover who’s been swimming naked” is very apt. In this case, the skinny dippers include the operators of pension funds’ generally perfectly prudent hedging strategies, which briefly turned toxic when UK government bond prices tanked far faster than stress testers had imagined possible.
The other name that keeps coming up is James Carville, once an adviser to US president Bill Clinton, who said in 1994 that he would like to be reincarnated as the bond market, because “you can intimidate everybody”. Like the Buffett quote, this quip is famous in markets. Both are so widely used because of the truths they reveal.
In the “mini” Budget drama, it was UK government bonds that really shook the system. Sterling’s precipitous dive to record lows on the Monday after Kwarteng’s speech was a sign of a country rapidly falling out of favour with international investors. It is no coincidence that these days Sky News places a widget showing sterling’s exchange rate against the dollar in the corner of the TV screen for UK political news bulletins.
But, as Carville would recognise, the UK government bond market was much more frightening. Bond investors balked, prices dropped fast and technical factors relating to pension scheme hedges quickly made matters worse. This, not the pound, is what forced the Bank of England to step in with a targeted rescue programme.
The intricacies of bond yields rarely trouble the general population, but homeowners quickly figured out what this meant for mortgage repayments, making it a searing political issue. Plus, it all jacks up the price tag for the government’s plans, ultimately forcing the chancellor to back down on some elements. All of a sudden people get why bonds, and bond investors, matter.
“The bond vigilantes are back,” says Gordon Shannon, a fund manager at TwentyFour Asset Management. “If governments have a plan, they need to think about market reactions.”
Governments were largely able to ignore markets in the period after the financial crisis as central banks pushed borrowing costs ever lower. Policymakers’ long fight with low inflation (remember that?) meant governments could always borrow on the cheap. Complacency set in.
High inflation has changed all that. Now, investors are much more fussy. “Companies that can sell their story can finance themselves at a better cost,” says Shannon. “This has not been part of a politician’s job for 15 years. It just has not been part of the game.”
Now that it is part of the game again, it is worth looking at what investors did not like. Governments should note that it was a mix of style and substance. “In my mind, this is a trust and confidence issue,” says Sondre Solvoll Bakketun, a bond fund manager at Norwegian investment house Skagen Tellus. “Having all that inflationary pressure and then more spending is generally not a good idea.”
Investors agree, though, that the real sticking point was the lack of oversight from the Office for Budget Responsibility, the independent body set up to scrutinise public finances. “I think it was the way it was presented,” said César Pérez Ruiz, chief investment officer at Pictet Wealth Management. “You need someone with credibility to come back and validate your plan.”
Making matters worse, Kwarteng’s repeated assertions that “markets will do what they will” gave investors the impression that authorities were happy to see bonds and sterling drop. “It said to markets ‘if you think it’s not right, have a go’,” says Pérez Ruiz. It took several days for Kwarteng publicly to acknowledge that the market ructions had “ruined his sleep”.
Now, as the BlackRock Investment Institute pointed out, credibility has been damaged, with real-world implications. “The sharp rise in UK gilt yields showed how higher rates can cause financial dislocations and disruption,” wrote the institute’s head Jean Boivin and deputy head Alex Brazier. “The UK is offering us a glimpse of the future for others.”
European officials reacted with a fair amount of schadenfreude to the UK’s financial market woes, but some countries might find themselves in similar quandaries soon, in turn forcing central banks to decide whether to keep firing up rates to quash high inflation or to restart support for fear of nasty financial accidents. Better communication would help governments to keep markets on-side, but they must remember they are playing to a tough crowd. “There is a limit to everything,” says Pérez Ruiz. “The UK was a wake-up call for the rest of the world that the market can say ‘enough’.”