London’s Financial Turmoil Might Be Heading to Wall Street

Plans to boost deficits blew up rates on the gilts. Sound familiar?

The Bank of England, in London, England. Yui Mok/PA

Commentary

British bonds, so-called “gilts,“ the UK equivalent of U.S. Treasuries, have been in turmoil since Chancellor of the Exchequer Kwasi Kwarteng announced a £30–40 billion tax cut last Friday. The supply-side tax cuts are intended to restore Britain to 2.5 percent annual growth.

But the cuts will put British finances further into debt because there is no corresponding cuts in government services, particularly the tremendously expensive National Health Service. The markets saw growing debt, as well as inflation, and responded to the measures by demanding higher interest rates, which was affected by the market lowering the value of the gilts.

Early on Wednesday, Eastern Standard Time, the prices of UK gilts took a battering from the markets. British pension funds that had put up their portfolio of gilts as collateral to borrow capital in order to enhance their returns suffered margin calls as the bonds fell in value, along with the value of the British pound.

The Bank of England (BOE) intervened to steady the markets and “to restore orderly market conditions” by promising to buy the longer-term gilts “with a residual value more than 20 years” (e.g., a 30-year gilt sold in 2013 with a maturity in 2043 and a residual value more than 20 years). The BOE said,  “The purchases will be carried out on whatever scale is necessary to effect this outcome.”

The BOE intervention stopped the hemorrhaging of the UK gilts, at least for now. But it raises serious concerns about the stability of markets, mostly in the United Kingdom, and around the globe as well.

And attached to the end of the BOE statement this morning was this tag, buried at the bottom of the release (MPC is the Monetary Policy Council, similar to the Federal Reserve Board):

“The MPC’s annual target of an £80 billion stock reduction is unaffected and unchanged. In light of current market conditions, the Bank’s Executive has postponed the beginning of gilt sale operations that were due to commence next week. The first gilt sale operations will take place on 31 October and proceed thereafter.”

In other words, the BOE was backing off from its planned reduction of its balance sheet, a reduction not unlike the planned reduction of the U.S. Federal Reserve’s balance sheet.

We Need to Be Wary

It’s important to note that while the pound is still a valued currency, it lost its status as the world’s reserve currency decades ago, when it was replaced by the U.S. dollar. The fact the pound is less significant than the dollar these days makes the pound much more vulnerable to the vagaries of the world’s sovereign debt markets, because lenders are concerned about the country’s ability to repay its debts, and—for foreign lenders—the value of pound when payment is made. (See, e.g., Japanese yen, once at veritable par with the dollar (1:100) 30 years ago, is now US$1:¥145 because its debt-to-GDP ratio has soared to more than 2.5:1.) The pound has similarly declined relative to what is now “King Dollar.”

Currently, the UK’s debt-to-GDP ratio is  85 percent of gross domestic product (GDP). But, again, it is no longer the world’s reserve currency as it was in the early half of the last century. The British economy is much smaller than that of the United States, China, or the European Union. So lenders have less need to hold the pound relative to the U.S. dollar, et al. With less demand, there is obviously less value and, thus, greater risk to lenders.

The U.S. dollar’s status as the world’s reserve currency—what was once called “an exorbitant privilege”—on the other hand, means that lending countries allow the United States to maintain a much larger balance of payments deficit than it would otherwise could.

Let’s assume a simple, bilateral case for purposes of illustration:

Country X sells its goods or services to County Y in exchange for Country Y’s currency. Having no use for Country Y’s currency in Country X, Country X then uses the Country Y currency it has earned to do one of three things: 1) buy Country Y’s exports; 2), buy Country Y’s assets (factories, land, stocks, etc.), or 3) buy Country Y’s sovereign debt.  So if Country X has a current account balance of payments deficit—meaning, Country X bought more from Country Y than it sold to Country Y—then Country X can either buy Country Y assets, like factories or stocks, or Country Y government bonds.

Country X here is the functional equivalent of China and Country Y is the functional equivalent of the United States. Because of the U.S. balance of payments deficit, China (and several other of our trading partners) have excess dollars that they all need to return to the United States. The excess of those funds, after China purchases U.S. goods and services, are invested in U.S. assets such as properties, stocks, and U.S. Treasuries. This allows the United States to finance its $31 trillion national debt.

But the dollar’s “exorbitant privilege” under this scheme may be at risk.

Ratio of U.S. Debt to GDP, 1940–2022

In 1981, when President Ronald Reagan pushed through his supply-side tax cuts and passed his Economic Recovery Tax Act to stimulate a lackadaisical U.S. economy (much as Chancellor Kwarteng is planning for the United Kingdom), the U.S. debt-to-GDP ratio back then was about 31 percent. Today, the ratio is 123 percent of GDP—higher, even, than it was during World War II.  While the ratio has come down somewhat as GDP increased after the pandemic, it is still exorbitant and begs the question for lenders: with inflation in excess of 8 percent, how much will those dollars lent to the U.S. government be worth when we are repaid in 30 years? Those lenders who think “not much” will likely demand higher interest rates, so that bond values will decline further.

Market Yield on U.S. Treasury Securities at 30-Year Constant Maturity (quoted on an investment basis, 9/17–9/22)

Thus, the United States potentially faces the same kind of liquidity crisis the United Kingdom faced this morning.

The Fed, like the BOE, is tightening credit with higher rates at the very same time it is allowing its balance sheet of Treasuries and mortgage-backed securities to burn off to the tune of $95 billion per month. Thus bond values are falling and, consequently, bond rates are increasing. As illustrated above, the interest rate on the 30 year Treasury has spiked, and rapidly, to its highest rate since November 2018. On Wednesday, the yield on the 30-year bond briefly reached 4 percent, but then the rate fell, and as it did, the market rebounded from the doldrums and closed up 1.8 percent.

It seems the markets believe the Federal Reserve will ease up on the tightening of the markets, as the BOE did on Wednesday when it delayed its planned sale of gilts until the end of next month. But if the Fed loosens monetary tightening to avoid a liquidity crisis, as the BOE did, or to avoid a recession, that should trouble—not encourage—the markets. It means the Fed has effectively lost control of monetary policy.

In summary, the global markets are decidedly unstable. There is a risk of a liquidity crisis in the United States, not unlike the one Britain experienced briefly on Wednesday, when margin calls on bond collateral forced sales and drove up rates. Such developments risk a downward—and rapid—spiral of bond values, further driving up rates. It has the potential to be a very dangerous and unstable time.

Investors should act with extreme caution. Begin by rebalancing portfolio toward cash and set stop-loss orders on brokerage accounts.

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