The UK debacle shows that the central bank’s ‘tough love’ is here to stay

In the past three weeks, the UK has given the world more “lessons to learn”, to use Bank of England parlance, than any other market since the US in 2008.

Entire textbooks will be written about the stunning scenes in the normally quiet UK bond markets since the 23rd September ‘mini’ budget, with chapters titled ‘Government policymakers: Don’t do this’ and ‘Or do this’.

One of the most important lessons for investors to heed is that central banks really, really mean business this time. They don’t care how much money you lose, even if global equities are down 26 percent this year without the usual counterbalance of higher bond yields.

They just can’t be dissuaded from a relentless rise in interest rates to quell inflation, which they didn’t see coming at first and then swore it was a blip. They are in no mood to do anything to encourage moral hazard or risk pushing inflation even further from their targets.

To recap the UK for those lucky enough to have missed it, markets around the world looked grim, inflation proved sticky and most major central banks slammed on the monetary brakes.

On September 23, Kwasi Kwarteng — who was chancellor when I started writing this column before he was sacked — stepped in with a “mini” budget that included the biggest unfunded tax cuts in 50 years and a huge surge in borrowing included growth assumptions that have not been subject to an independent external audit.

UK government bond markets rallied, prices fell quickly and technical issues related to hedging strategies caused certain pension funds to sell more. The BoE stopped this spiral by offering to buy gilts from them and later backed this up with further measures to improve liquidity and purchase inflation-linked bonds for a period through Friday.

All of this had already created more excitement among veterans of the Gilt market than ever before. But a fresh shock came late Tuesday this week when BoE Governor Andrew Bailey said he meant business: this support will truly end on Friday. No renewal of support.

Investors have been hard-coded for a decade and a half to believe that temporary bailouts can magically become semi-permanent, that central bankers will take care of them. But at an event in Washington, Bailey was outspoken. “We announced that we will be coming out at the end of this week. My message to the [pension] Money is you have three days left,” he said.

That went down like a cup of cold. My phone lit up with messages in unrepeatable words asking what on earth the BoE governor was up to. The consensus was that disaster was imminent. In fact, it turned out to be a masterpiece. Suddenly, drawdowns on the central bank’s bond purchase facility skyrocketed. Market participants realized that they could not wait and hope for the BoE to buy bonds from them at a better price. They had to do it – it really isn’t a form of backdoor financial support.

Line chart of 30-year UK Government Bond Yield (%) with Gilt Trip: wild ride for UK Government Bonds

Against all odds, the central bank managed to get the market under control and limit what appeared to be a disorderly rise in yields. Any form of more permanent support for market stability is likely to be very narrowly targeted.

“[The BoE] didn’t want anyone to think they were being saved,” says Tomasz Wieladek, economist at T Rowe Price. “The bar is set very high for central banks to turn around,” he adds, given blistering inflation.

That’s exactly the kind of tough love that investors have to live with. To quote the incomparable Björk (no ridiculous quibbles are entertained about her immense talents, so please don’t bother emailing me): Your rescue squad is too exhausted.

Some fund managers are finding it easier to adapt to this new reality than others. Ark Investment Management’s Cathie Wood — the doyenne of growth stocks and an advocate for innovation — belongs to the latter camp, perhaps unsurprisingly for someone whose flagship exchange-traded fund is down 63 percent this year. She wrote one this week open letter to the US Federal Reserve “out of concern [it] makes a policy mistake that will lead to deflation”.

Sounding irritated by the Fed’s latest 0.75 percentage point rate hike, Wood asked: “Unanimously? Really?” Three days after her letter, annual US inflation was reported at 8.2 percent, just a touch below the previous month’s reading of 8.3 percent. It’s fair to wonder why aggressive rate hikes are still going on show no discernible success in bringing down inflation, but the answer has to be yes, really.

The Fed does not operate in a vacuum. “Several participants noted that . . . It would be important to coordinate the pace of further monetary tightening with the aim of mitigating the risk of a material negative impact on the economic outlook,” she said at their last meeting protocol.

But that’s far from a serious suggestion to consider a milder route. Bad news for economies and real life is often good news for markets, as it suggests central banks could be more generous to the financial system. But it’s becoming increasingly clear that we would need a really terrible shock for this to work now. The UK debacle shows that the central bank’s ‘tough love’ is here to stay

Adam Bradshaw

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