It’s the QT, stupid
UK bond markets are calmer now after last week’s tempest, but this might just be the eye of the storm
Having spent most of last week fervently denying it would have to withdraw some of the main prongs of its mini-budget set out on Friday, September 23, the UK government is now feverishly turning 180 degrees at every opportunity.
The 45% income tax rate for high earners that chancellor of the exchequer Kwasi Kwarteng promised to scrap will now stay.
The chancellor has committed to bringing forward his plans to reduce the deficit. And he has, at last, had a sitdown with the independent Office for Budget Responsibility. It will accelerate publication of its UK economic forecast — an early but influential verdict on Kwarteng’s growth ambitions.
Spinning on its heel is not a good look for a government, especially a new one. Indeed, last week GlobalCapital argued that a u-turn would be too humiliating to stomach and that the Bank of England would have to cede ground, instead.
We are happy to have been wrong in this instance. While embarrassing for Kwarteng and prime minister Liz Truss, the reversal was the right thing to do. The recovery of equity and Gilt markets on Monday and Tuesday confirms that.
Truss and Kwarteng might have looked like chumps with rictus grins at the Conversative Party conference this week, but they had little choice, given the level of opposition in their own party.
However, relief will only be temporary. While fiscal prudence needs to be restored, the real battleground from the markets’ point of view is monetary policy — specifically, what the Bank of England does with the vast stock of Gilts it has accumulated since November 2009.
While the tax cuts might have been politically unpalatable, what really scared the bond market was quantitative tightening.
As of September 28, the Bank held £838bn of Gilts and had said it would start reducing this stock by £80bn a year through sales and run-offs. In the Bank’s words: “Given the profile of maturing Gilts over this period, this would imply a sales programme of around £10bn per quarter over the 12 months from September.”
Sentiment and timing
A 10% reduction a year might not seem very much. But as the chancellor found with his 45% rate policy (which had been costed at just £2bn of the annual tax pool of £900bn), sentiment and timing can be more important than absolute numbers.
After 13 years QE has become a drug that the market has made painfully clear it does not want to do without, especially right now with a new government finding its feet (to put it generously), already high debt levels, looming recession, out of control inflation, and war in eastern Europe.
To calm markets amid Kwarteng’s kerfuffle last week, the Bank delayed the beginning of quantitative tightening from this week until October 31 and had to introduce a mini-QE of up to £65bn, offering to buy £5bn of long dated Gilts every working day from September 28 to October 14.
In fact, the Bank has achieved its aim of restoring orderly functioning to the Gilt market with a much smaller outlay: £3.7bn so far, over the first five days. On Tuesday October 4 the Bank decided not to buy any of the £2.25bn of paper it was offered.
But it surely needs to be thinking longer term than this. Based on the evidence of the last two weeks, markets, while calmer now, are still raw and unlikely to accept QT.
The government might be backing down on its tax cuts, but inflation, war, high debt and economic slowdown will be with us for the foreseeable future.
It’s all very well thinking the Bank of England has an advantage over the European Central Bank in that it can do what it likes, including turning on the printing presses at the drop of a hat. But that requires the markets to trust that the Bank will do the right thing. On occasion over the last year markets have been caught out by the Bank’s decisions, over interest rate rises for example. This is not a central bank to make assumptions about.
So rather than just respond to the next crisis, by definition belatedly and after much damage has been done, it should be designing and installing a permanent back-up plan, like perhaps, the European Central Bank’s Transmission Protection Instrument.
Though this mechanism has been created to paper over fundamental cracks in the eurozone, at least the ECB has got ahead of the game.
Is it any coincidence that European government bond yields have been less volatile than their UK equivalents?
As the ECB has shown, it’s all about the QT.