The gilts sell-off hints at much deeper problems
Yesterday gilt markets sold off sharply. No doubt this was a headache for both the government and the Bank of England (BoE), who thought they had got the selloff under control at the start of the month. Yet 30-year gilt yields have now surpassed 4.5% once more and are rapidly climbing back up to past 5% — where they stood prior to the BoE intervention earlier in the month.
Gilts are the markets that the British government taps to finance its borrowing. The interest rate on this borrowing is set jointly by the financial markets themselves and the BoE which provides guidance. Typically, the BoE and the markets work together to set rates, but right now they are working at cross purposes. This shows a disconnect between how the markets perceive the realities of British government finances versus what the BoE wants these realities to be.
The sell-off undoubtedly shows that financial markets are still concerned about the government’s spending plans, despite the Chancellor promising to publish forecasts of the plan earlier than previously stated. But there are far deeper dynamics at work here that, still, no one wants to discuss.
At the beginning of September, long before the much-maligned mini-budget, Deutsche Bank analyst Shreyas Gopal published a note on the British election. Gopal pointed out that the huge increase in energy prices triggered by the sanctions and counter-sanctions on Russia would lead to a blow-out in the British trade account with the rest of the world, estimating that it would rise to 10% of GDP. Given that Britain relies on the City of London’s capacity to attract capital flows in order to run trade deficits, the analyst claimed that 10% of GDP would be a bridge too far for markets.
It is these underlying forces that make the action in the gilts market so ominous. If the selloffs were simply domestic pension funds shedding their long-term government debt, the BoE could step in and provide the liquidity needed to allow the funds an orderly exit. But if the selloffs indicate foreign capital fleeing the British financial system, then we could be facing down the currency crisis that Gopal and others predicted.
Since then, the situation has only gotten more volatile. The apparent sabotage of the Nord Stream gas pipelines in late-September made it appear that even if Europe wanted to remove the sanctions on Russia in exchange for piped gas, they no longer had the option. Since then, Russia has stated that Nord Stream 2 was only partially damaged and that if Europe removes the sanctions, Russia can attempt to pipe gas through it.
Moves in the market for sterling suggest that this could be the case. The day before the mini-budget was announced, sterling stood at £1.13 against the US dollar. On the day of the mini-budget it fell to £1.08 — an enormous 4.5% decline in a single day. Since then, sterling has bounced around and today sits around £1.10.
While it is currently difficult to prove, the firming up of sterling suggests that the BoE is likely undertaking another intervention behind the scenes: namely, selling down its foreign currency reserves. This would be a much more important intervention than the gilt purchases because the BoE only has so many foreign reserves to sell down. If it runs out of ammunition and international capital continues to flee, sterling could collapse.
As of September, the BoE had around $78bn in net foreign reserves. That is enough to fund the current trade account ($33.8bn) for around six months. But if the trade account blows to 10% of GDP as Deutsche Bank estimates claim, then BoE’s reserves will only be able to fund this for less than two months.
Properly read, today’s statement by the IMF confirms this analysis. While the IMF did criticise the British Chancellor’s budget, the focus was on its impact on income inequality and how the cost-of-living crisis would hit working people. Meanwhile, the body’s statement focused much more firmly on the trouble facing the world economy due to the impact of the war in Ukraine. The IMF knows that Britain’s problems are primarily caused by the impact of the war and sanctions; the dodgy budget is just the icing on the cake.
It is imperative that policymakers in Britain start to understand that the serious economic crisis that this country faces is a direct consequence of the sanctions policies imposed on Russia after it invaded Ukraine. These sanctions have had a limited effect on Russia, and a much worse effect on us. Through rising energy costs — which hurts the British trade account — they risk permanently lowering living standards in this country. It is only when we start addressing these issues that we might be able to find a way out of this crisis.