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Anarchy (and not only) in Great Britain

Increases in bond yields may not exceed overall inflation.

Liz Truss’ short and unfortunate tenure saw British politics and markets explore new depths of volatility and instability. Together with Kwasi Kwarteng – her first choice for finance minister – she launched her “Trussonomics” platform, a series of unfunded tax cuts designed to boost growth.

But why have markets reacted so negatively to policies aimed at addressing Britain’s structural weaknesses as it has separated from its most important trading partner? The main reason was, of course, concern over the sustainability of the public debt. According to the UK’s Office for National Statistics, debt as a percentage of GDP fell from 85.5% in the fourth quarter of 2019 – just before the pandemic – to 101.9% in the second quarter of 2022. The cost of servicing debt has also exploded, as shown in the chart below taken from data from the Office for Budget Responsibility, which was last updated in early May. Since then, the problem has gotten even worse – the yield to maturity on ten-year government bonds (Gilts) has more than doubled, from 1.8% on average in April to 4.0% in October .

Britain’s struggles were exacerbated by the side effects of more than a decade of low policy rates and quantitative easing, which prompted a rush for returns among investors. This was particularly true for UK pension funds, which found themselves unable to meet their obligations with ten-year Gilt returns reaching just 0.1% in 2020. This situation led many funds to enter into swap contracts promising higher returns , provided that the return on Gilts does not exceed a certain limit. The rise in yields triggered by Trussonomics exceeded these thresholds, forcing pension funds to sell their most liquid assets – often Gilts – to meet margin calls on swaps.

Although growth is weak, the demographics indicate that the labor market is tight and unemployment is at its lowest level in generations.

However, the UK is not an isolated case. According to the International Monetary Fund’s October 2022 Fiscal Monitor, gross debt to GDP in the euro area fell from 83.8% in 2019 to 93.0% in 2022 and from 108.8% to 122.1% in the United States. As for budget balances, they should remain in large deficits next year – -3.3% and -5.7% respectively, according to the IMF. In addition, negligible or negative interest rates in recent years have led investors to seek returns, as in the UK. But as market participants well know, you don’t get something for nothing – improving returns necessarily involves either more credit risk, more leverage or a combination of both. The fact that an English-style crisis has not yet erupted elsewhere is hardly reassuring – Britain’s short-lived flirtation with Trussonomics has shown how quickly things can deteriorate.

The rise in policy and bond yields – which will challenge the sustainability of public finances across developed economies – was triggered by the rise in inflation following the shutdowns. This increase has both cyclical and structural reasons. As for cyclical causes, supply chain disruptions played a significant role. They are shrinking, but the concerns will not go away – worsening relations between the US and China are expected to accelerate the trend of relocation of production sites, which will lead to higher costs in the long run.

Inflation is voters’ biggest concern, and they expect central banks to address it.

After a decade of paltry rates, inflation remained stubbornly low until governments were forced to introduce massive fiscal stimulus to cushion the effects of shutdowns. The simultaneous implementation of accommodative fiscal and monetary policies fanned the flames and ignited today’s inflationary fire. These two trends are reversing, but their side effects are likely to continue. This is particularly visible for salaries. Although growth is weak, demographic factors mean the labor market is tight and unemployment is at its lowest level in a generation. Together with the relocations, it strengthens the workers’ bargaining power, and it is to be expected that wage demands will continue to rise.

However, there is a glimmer of hope. Higher inflation means stronger nominal GDP growth, which helps improve the debt ratio. Of course, it would hardly matter if debt servicing costs rose faster than inflation – governments would have to issue new bonds to finance higher interest rates.

Central banks are therefore in a difficult situation. Inflation is voters’ biggest concern, and they expect central banks to address it. However, the authorities also know that a structural increase in prices would ease much of the debt they have on their balance sheets. There is no magic solution and central banks will likely have to navigate on sight. This means higher interest rates to give the appearance of fighting inflation, but little real will to bring inflation back to their 2% target. This means that increases in bond yields may not exceed overall inflation, assuming a very unfavorable long-term environment for bond investors.



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