What is happening in the UK – is the economy crumbling?

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I’m struggling to think of a more inauspicious start to a political reign than Lizz Truss’ as Prime Minister of the UK.

Scarcely a minute into the role, she announced what has turned into an utterly disastrous mini-budget, throwing the UK economy into disarray. But why is it all happening? And what does it mean? Are pensions safe?

What happened?

In summary, Lizz Truss’ mini-budget was seen as overly aggressive. Alongside Kwasi Kwarteng, Chancellor of the Exchequer, they announced a bunch of tax cuts. That sounds great – nobody likes paying tax. However, money doesn’t grow on trees, and these tax cuts were unfunded.

This means the government will have to ramp up borrowing. It also means a setback in efforts to combat the cost-of-living crisis, something I have been writing about all year. with the IMF affirming in a rather understated style this week that they believed the budget was “complicating the fight against inflation”. It also predicted the crisis would persist for longer in the UK than other similar economies.

The budget has shot confidence in the UK economy – mostly evident in the collapsing pound and the unprecedented sell-off in gilts (bonds). Gilts are trading at yields not seen since 2002, while the pound is at all-time lows against the dollar.

What is happening pensions?

The problem regarding the sell-off in gilts is that pension funds rely on these assets to hedge their liabilities. This is what is known as liability-driven investing. Essentially, they match the fixed cashflows of gilts against their liabilities (i.e. what they pay out to pension holders).

With the sell-off in gilts so severe, these liability-matching pension funds were margin called on the gilts they held. This meant they had to post more collateral against their positions.

Of course, this only led to even more selling, as the funds were required to raise cash to post against these margin calls, which they did by selling the very same assets. This caused a further fall in prices, which caused more selling – and round and round we go on the merry-go-round of doom.  

The Bank of England hence stepped in to buy these bonds, given the risk to financial stability that the meltdown would cause. The latest announcement this week appears to show the support will end by October 14th, meaning there could be a further sell-off in gilts, although there are calls for the Bank to continue support until the end of the month.

Is my pension safe?

While the sell-off is hugely concerning for the economy at large – more on that in the final section –  pension holders should not be overly concerned.

The Bank has made it clear that it will not allow financial stability to ripple like contagion, while pensions will be – and are – getting defended vociferously. This is a liquidity crisis at the end of the day, with the sell-off exacerbated by this thirst for cash to post against margin calls.

Besides, once these issues are actually overcome, the bonds held by pensions should pay a higher rate of interest over the long-term.

The doomsday scenario is whether more pensions than anticipated have been getting fruity with complex investment instruments, such as wonky derivatives that have gotten caught up in the mess. This could cause funds to lose value, however it remains a remote scenario and one that, in any case, would affect only a minority of pensions.

What does this mean for the UK economy?

This is a colossal blow for the UK economy. I don’t think it can be overstated.

Already facing rampant inflation and behind the US Federal Reserve with regard to interest rate rises, the pound has been, well, pounded into oblivion.

The cost of borrowing for the government has risen. Further interest rate hikes are likely now necessary to reel in inflation, driving mortgage costs upward. With the energy crisis already looming as we enter into winter, with talks of power grid failures and people struggling to afford to heat their homes, it could not have come at a worse time.

The FTSE stock index has sold off aggressively. Sentiment is through the floor. It’s quite the start all round.

In truth, perhaps the worst of all is the blow to credibility. When the UK is looking to establish itself as one of the biggest economies in the world, and now independent from the EU, episodes like this cannot occur.

The economy is still reliant on foreign investors – it does not boast the strength of the US economy, whereas it imports a much higher proportion of its energy – and in the current dollarised, high-inflation environment, a misstep like this is a torpedo to the UK’s market credibility (I wrote about why we are all subject to the reign of the dollar here).

How did this happen?

I have no answer to this.

This was an entirely predictable scenario. Akin to when you drop a ball from your hand, you know the ball will hit the ground – because that is how gravity works. Similarly, announcing a raft of tax cuts amid an inflation crisis will obviously lead to a sell-off in bonds and jack up the cost of borrowing, while your currency will get hammered.

It really is that objective; there is no grey area.

And yet, it happened anyway. I really don’t know why.

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