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Wednesday, September 28, 2022

Gilt Market Mayhem!

Bond markets are finally getting interesting, with the Bank of England launching emergency purchases to restore order in the gilt market. Since I am not in constant contact with people trading gilts, I will just offer a tentative description of what seems to be going on, and what it “really means.”

Disordered Markets

The Truss government launched an expansive “mini-budget” that was not received well by the forex and bond markets. The Bank of England did not do an emergency hike in response, which is a point I return to later. Gilt yields rose rapidly, consistent with a higher terminal rate.

However, the sell off became disorderly. The culprit that has shown up in market chatter are pension funds that entered into swaps to generate duration to match their liabilities. Using swaps instead of buying bonds means that the cash that would have been invested in bonds can instead be used to buy risk assets that offered higher prospective yields. This structure is essentially equivalent to a levered position in risk assets: borrow against bonds to buy risk assets.

Although the pension funds will have liabilities that decrease in value that offsets the interest rate losses on the balance sheet, the problem is that lower actuarial liabilities do not generate cash flow. There are margin calls to be met for the swap positions, and raising the cash immediately is not easy if locked in with other managers.

At the same time, everyone aware of this situation sniffs blood in the water and is going to squeeze those positions unmercifully. The gilt market is notoriously insular — similar to Canadian markets — dominated by a handful of large players who have a good idea about other players’ positioning. Not the sort of market you want to be in if you face large margin calls.

Bank of England Options

The Bank of England had to choose between two options today.

  1. Let the pension funds be squeezed into oblivion. Because free markets, lol.

  2. Do what it did — buy long-dated gilts with the explicit objective of restoring order to markets. That is, squeeze the shorts who were squeezing the liquidating longs.

The economic effect of letting the gilt market to melt down appears straightforward — many things would break, particularly the over-extended housing market — and the U.K. would be looking at a downturn at least as vicious as 2008 in the United States.

If order is restored to the gilt market, the BoE can methodically raise rates to deal with inflation problems. This might cause a recession, but it is much less likely to be a sudden stop.

Liquidationists Come Out of the Woodwork

As anyone with experience in interest rates would expect, government bond liquidationists have been out in full force, denouncing the BoE intervention.

  • All the people who have been predicting G7 balance of payments of crises for the past few decades are doing victory laps.

  • The left wants a meltdown to make the Truss government look bad.

  • Neoliberals are jabbering on about fiscal dominance and central bank independence. I will discuss these points next.

Central Bank Independence

One common complaint is that this episode has encroached upon central bank independence. Which just tells us that “central bank independence” means to these people “central banks can do whatever they want.” In the real world, governments grant bodies “independence” — but those bodies have norms to follow. Importantly, they cannot inject themselves into partisan politics.

Up until today’s intervention, the Bank of England did exactly what it is supposed to do: wait until a regular meeting date to adjust the policy rate in response to changes in economic conditions. Fiscal and monetary policy work with a lag: there is no reason that waiting a few weeks ultimately makes a difference. Term interest rates rose immediately, which is supposedly good enough for interest rate regulation of the economy over the very short term.

Conversely, an emergency rate hike in response to the fiscal statement — which is what some of these loons apparently want — would be a direct central bank intervention into partisan politics. Conversely, waiting until the next meeting gives the central bank plausible deniability about the effects of fiscal policy on the decision.

Fiscal Dominance: Last Refuge of Scoundrels

Finally, neoclassicals unsurprisingly invoked “fiscal dominance.” Fiscal dominance is just a code phrase for “fiscal policy I do not like.”

I discussed the problems with the concept in a 2020 piece.

When I looked at fiscal dominance, I was struck at how much hand waving was involved in discussing the concept. Neoclassicals loudly yell to the rooftops about how they use mathematical models, and are superior human beings because they studied Real Analysis (lol). But when fiscal dominance comes up? Welcome back to handwaving literary economics!

If we wanted to strip out the biased political stance behind the concept (spoiler: fiscal expansion bad), we get the amazing concept that the central bank needs to take into account fiscal variables (debt and deficit levels) when setting interest rates. Considering that fiscal policy is independent of the central bank — the flip side of central bank independence — that just means that the central banks need to take into account the state of the economy when setting interest rates. Well, duh.

Believers in this nonsensical concept would likely rage at that description and say that there is more to it. The alleged problem is that the central bank needs to take into account the possibility of a “fiscal crisis.” However, we rapidly run into the reasons why they need to use obfuscation to discuss this issue.

  • If the “fiscal crisis” is a default (because debt/GDP, vigilantes, whatever), we are back to MMT debates. Neoclassicals have now taken the stance that they knew all along that floating currency sovereigns are not subject to involuntary default, so they cannot suddenly appeal to default risks without showing themselves to be lying weasels.

  • If the issue is that increasing interest rates when the debt level is high poses inflation risks, we see that perhaps “basic macroeconomics” is wrong about interest rates and inflation.

  • If the “fiscal crisis” is just the bond market becoming disorderly due to rapid yield changes (as is allegedly the case in the U.K.), that is just a financial stability mandate issue. A short-term intervention to restore order is called for — since a disorderly market implies that yields are not at levels consistent with the central bank’s reaction function to stabilise inflation.

Concluding Remarks

The government bond market is the most hated market. Whenever it sells off, political hacks come out of the woodworks to claim that they are vindicated. Although being a political hack is fun, it can be dangerous to investors — you cannot extrapolate yield changes to infinity. Markets do overshoot — but you need to cover positions at some time.

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(c) Brian Romanchuk 2022


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