The Markets Made Me Do It!

British Prime Minister sacked the Chancellor of the Exchequer (head of Treasury) Kwasi Kwarteng on Friday, and economic commentary was predictable. Variations of “markets force government to backtrack!” were abundant, and echoed by Labour Party supporters (which would be surprising for anyone unfamiliar with British politics).

Of course, this is a variant of the “bond/currency vigilantes” stories that neoliberals love, and so features prominently in market discourse.

Primer: Basics Of A Swap Meltdown

I am now seeing more attempts to dig into what exactly happened in the United Kingdom interest rate market. In this article, I am not attempting to do that. Instead, I am just giving a primer on how interest rate swaps are used to hedge liabilities, and what can go wrong when interest rates rise. The mechanisms I describe were likely part of the issue, but I am not saying that this is “the” explanation. Since most people are unsure what liability-driven investment and swaps are, so I am hoping to cover big picture issues for those readers.

I have not seen too many longer articles about the “gilt crisis” in the United Kingdom, but have seen a variety of reactions on Twitter. My reaction is that the discussions reminded me why I mainly followed people who used the title “rates forecaster” and not “economist” when I was in finance. (The “rates forecasters” might have had economics degrees, but they knew that if they wanted people like me to take them seriously, they needed to not sound like the people with “economist” in their title.) It is rather impressive how the most interesting part of this crisis has been buried.

We finally have had the financial instability crisis that everyone was a bug about throughout the 2010s. Many people have spent more than a decade calling for a repeat of the Financial Crisis — well, we just had a small version of it. Based on the initial reporting (which may not be perfect), pension funds managed to blow themselves up with leverage (created by fixed income derivatives) by crowding into one side of a trade. This alleged distress forced the Bank of England to intervene to reduce gilt yields (and hence swap rates).

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.”

U.K. Fiscal Policy: Boom

I normally stay away from commentary on budget statements, in that the analysis is mainly political in nature. In recent decades, the macro fiscal effects tended to be tepid and over-rated for political reasons. (The pandemic measures are the glaring exception, however, they were often enacted as stand alone measures and not part of the normal budgeting process. The same holds for the various fiscal measures enacted in 2008.) The recent “mini-budget” in the United Kingdom threw away that timidity. Since I have not been following the area closely, I will point you to Duncan Weldon’s piece, and offer a more theoretical response.

Primer: U.K. Index-Linked Gilts

Her Majesty's Treasury of the United Kingdom was one of the earliest modern issuers of inflation-linked bonds, with issuance starting in 1981. (There were earlier bonds that featured some form of indexation, but those were less systematic in design.) Unfortunately, the original design used is much harder to work with than the structure used by Canada ("Canadian model").

The Revenge Of Policy Uncertainty

Unless someone gets cold feet, the British government is expected to trigger Article 50 on Wednesday, starting the process of the United Kingdom leaving the European Union (EU). Although markets are not panicking about this move (yet), this obviously creates a great deal of fundamental uncertainty about the outlook for the British economy. I do not have any strong opinions on what this means for the United Kingdom, but I believe that the effects should be largely localised to that economy.

The Calculus Of Crisis

The last remaining drops of yield  are being wrung out of the global government bond market while bears run amok. Although the adage "He who panics first, wins!" must be kept in mind, it is still not obvious whether or not this a re-run of previous summer silly seasons in financial markets.

Another Example Why Bond Investors Ignore Developed Sovereign Credit Ratings

Fitch and Standard & Poor's both downgraded the U.K. to AA (from AAA) this week in response to the Brexit vote (politico.eu article). As experienced market watchers would expect, U.K. gilts have been rallying (yields falling), which is not the usual narrative that one hears about ratings actions. This article explains why bond investors treat credit ratings for free-floating developed sovereign governments as sources of entertainment, and not investment guidance.

Brexit - A Cautious Panic

For those of us outside the United Kingdom, the "Leave" victory in the referendum is not enough to cause worries about the real economy. We have entered the thin summer market period, so some form of financial turbulence is likely, but until some defaults occur it is not going to matter for non-levered investors. For the U.K., the most likely outcome is going to be an extremely long period of technical negotiations, which will eventually be pushed out of the news cycle by news about the Royal Family and football.

How To Deal With Imported Inflation...

Although I should be enjoying the Fête Nationale du Québec, I just wanted to update the chart above. I first used it in this article, which discussed U.K. inflation. The point is that VAT changes can have a very large one-shot effect on inflation, and at an order of magnitude similar to the effect of currency changes.

Re: Brexit

I added some extra comments to my Brexit article; I will wait for the dust to settle before writing anything longer. In any event, it's a holiday here in Québec today...

Brexit Analysis (Why I Avoided It)

The United Kingdom is holding a referendum with regards to European Union membership on June 23rd (link to BBC explainer).  This  brief article explains in point form why I have largely avoided the topic. (UPDATE: Based on the results, I probably should have kept avoiding the topic...) I will return to the consequences of the vote once the dust settles.

VAT Hikes And Inflation: U.K. Edition

One of the problems of studying inflation in a low inflation environment is that special factors may have a larger impact than underlying economic forces (like the output gap, wages or import prices). This makes inflation modelling difficult, and data interpretation is strained if you do not take those special factors into account. One of the largest impacts can occur from Value-Added Tax (VAT) hikes, which mechanically raise the price level in a country. The chart above shows the experience of the U.K., where various tax hikes raised CPI inflation by almost 2% in 2010-2011. Despite the belief that bond investors are supposed to have a Pavlovian aversion to inflation, this was actually bullish for bonds. I discuss this point here, as well as the issue of U.K. inflation sensitivity to the pound.