Britain’s reputation for sound money is being swept away, writes ALEX BRUMMER 

Britain has long had a reputation for sound money. But in the wake of Kwasi Kwarteng’s mini-Budget, the markets have relentlessly pushed that reputation aside.

Historically, government bonds have been the safest place to invest in advanced countries. In the case of the UK, these bonds are known as gilt-edged stocks because they were always considered as good as gold and the original certificates of ownership had gold-edged.

From time immemorial, they have been provided by governments to investors to finance their credit needs.

During the two major catastrophes of recent times – the great financial crisis of 2007-09 and Covid-19 – the gold market remained largely insensitive to events, despite government debt soaring to about £2 trillion, essentially the value of the output for the entire UK economy.

catastrophic

Much of this was due to the careful management of public finances by successive Tory administrations that kept the debt from growing even higher. Other developed countries have even allowed their debt levels to rise well above 100 percent of output.

However, all that good work has now fallen apart.

It’s not just that the International Monetary Fund this week reiterated its doubts about Britain’s economic prospects. Or that the Institute for Fiscal Studies has warned that the government faces a £62 billion black hole in its financial plans.

Chaos now reigns in the financial markets as price movements in gilt-edged stocks – normally a calm but stabilizing boost in the financial system – are unprecedented in their magnitude.

This may seem like a mysterious matter far removed from our everyday life. But the truth is that gilt-edged stocks and the health of the gold-plated market are an important factor in the economy.

If investors lose faith in government bonds, it is a clear sign that they are losing faith in Britain’s financial stability. And that gets us all in trouble, especially in the form of higher interest rates and mortgage payments, but also potentially catastrophic problems for pensions.

The Bank of England’s intervention in the gold market in recent days – offering to buy up to £65 billion worth of gold-edged equities to preserve financial stability – is a measure of how concerned we should be.

Nothing like this has happened since Britain was kicked out of the exchange rate mechanism (ERM) in 1992, the forerunner of the eurozone that pegged the value of the pound to that of the Deutschmark.

At the time, the Bank proposed raising interest rates to a staggering 15 pc. in an effort to support sterling and the gold market, before the mark was believed to be untenable and we exited the ERM.

This time, the Bank’s first intervention, two weeks ago, was to contain a crisis in the so-called long-term government bonds: government bonds with a maturity of 30 years. This turned out to work. The market recovered for a while.

But now the Bank has had to intervene again after the contagion has spread to another part of the gilt market: index-linked bonds, whose yield is linked to inflation. This is an indigestible sign of investor concern.

As I mentioned, UK gilts have long been considered the safest investment. They are a guarantee of repayment – in effect an IOU – from the government of a first world country that has never defaulted. They have always been considered inviolable.

The response from the Bank of England and other regulators after the banking crisis of 2007-09 – when defaults occurred on all kinds of debt – was to require banks, insurance companies and pension funds to increase their holdings of gilts because they are so safe.

The move was intended to protect pensioners from the extreme volatility that is hitting the markets in stocks, real estate and other more exotic assets such as private equity and hedge fund investments.

But if gilts were such solid investments, why did the market flip?

The presentation of Liz Truss and Kwarteng’s £45 billion in unfunded tax cuts and failure to properly audit the Office for Budget Responsibility led to chaos. As a result, the value of long-term gilts fell and institutions that owned gilts, such as pension funds, began to sell.

All of this has been fueled by the fact that financial institutions have taken on new risks in their quest for better returns on defined benefit plans – which provide the savings of some ten million people. They decided to make the assets work harder in the belief that this would help correct the shortcomings in many schemes.

Toxic

As someone who served on a private fund’s “investment committee,” I recall several presentations from outside pension fund advisors to the trustees encouraging them to use complex debt instruments, known as derivatives, to improve returns.

As for me and at least another trustee, if it was impossible to understand the complexity of the financial instrument, then it was best to stay clear.

But that hasn’t stopped the industry from using these derivatives — or Liability Driven Investments (LDIs) — to exorcise retirement plans by increasing the levels of debt used against the gilts they owned.

Today, the city has over £1 trillion in LDIs working to improve return on defined benefit plans.

But just like during the financial crisis, the battle for higher yields proved extremely toxic.

City firms such as Blackstone, Legal & General and Schroders increasingly encouraged lending against gilts, and the money raised from this was reinvested in more and more government stocks.

That was fine in normal trading conditions. But the mini-budget caused markets to grab sterling and embark on a dramatic sell-off of long-term gold investments, which fell sharply in value, leading to hikes in interest rates.

Affected

Regulators had stress-tested LDIs for a full percentage point change in gilt interest rates. But the rate change soon reached 1.6 points, triggering a cascade of sales as leverage or loans had to be paid off. This threatened insolvency for lenders and an earthquake for pension funds. And the Bank of England had to intervene.

The support operation is expected to end on Friday – fueling renewed market nerves over gilts – but the Pensions And Lifetime Savings Association is now demanding that support be expanded.

Today Bank of England Governor Andrew Bailey said the bank would not extend its support beyond the end of the week, leading to an immediate drop in the pound as affected pension funds rush to raise hundreds of millions of pounds .

As the problem spreads to indexed bonds – the most sensitive area of ​​the government bond market – pension funds feel dangerously vulnerable, as they own 72 percent of indexed government bonds.

The drama has received worldwide attention. At the annual meeting of the International Monetary Fund, which I attend in Washington, Tobias Adrian, the Fund’s top supervisor, said that Britain paid the price for having two people at the wheel, “each driving the car.” tried to steer in a different direction’. .

In other words, the Bank of England’s policy of tightening interest rates while easing fiscal policy with Kwarteng tax cuts was a mistake.

Be that as it may, the fact is that gilts – once the gold standard for investment in this country – have been tarnished. And that is of great concern to Britain.