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Dissecting What Happened to the Pound This Week
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Absolute MAYHEM in the currency markets.
In the global scoreboard called the foreign exchange market, there have been so many moving pieces behind the scenes it’s getting harder and harder to keep track.
While some are calling recent Fed actions a policy error, over in the UK, we are seeing questionable decisions on the fiscal side of the equation as the government put forward tax cuts. Talking heads (and even the IMF?) were quick to condemn these decisions.
After the bond market went haywire, the BoE had to step in to avoid a crisis.
This means we finally got to talk about a Central Bank that wasn’t the Fed.
For the purpose of this week’s version of the free newsletter, we will be covering exclusively what is happening with the pound… but there are much more important consequences for recent government and Central bank policy in another currency - the US dollar.
Paid subscribers will get access to the issue that does a deep dive into the current runup in USD, the incoming liquidity crisis, and a more global macro readthrough.
This week, in <5 minutes, we’ll cover the recent moves in the pound:
What Happened on the Fiscal Side? 👉 Tax Cuts
Monetary Response 👉 Using QE to Prevent Crisis
Pension Funds 👉 Where Do They Fit In?
Let’s get started!
1. What Happened on the Fiscal Side? 👉 Tax Cuts
This was and still is an ongoing roller coaster of events.
On the previous Friday (Sept 23), under new PM Liz Truss, the UK’s new finance minister Kwasi Kwarteng put forward a mini-budget that outlines a plan to grow the economy by cutting taxes and sharply increasing government borrowing.
They announced that the government will cancel a planned rise in corporation tax to 25%, reverse a recent rise in income tax, and cut taxes for businesses in designated investment zones. By the Bullets:
Cancellation of a planned rise in corporation tax to 25%, keeping it at 19%, the lowest rate in the G-20.
A reversal in the recent 1.25% rise in National Insurance contributions — a tax on income.
A reduction in the basic rate of income tax from 20 pence to 19 pence.
Scrapping of the 45% tax paid on incomes over £150,000 ($166,770), taking the top rate to 40%.
Significant cuts to stamp duty, a tax paid on home purchases.
A network of “investment zones” around the U.K. where businesses will be offered tax cuts, liberalized planning rules, and a reduction in regulatory obstacles.
A claim-back scheme for sales taxes paid by tourists.
Scrapping of an increase in tax rates on various alcohols.
Scrapping of a cap on bankers’ bonuses.
The government estimates the tax cuts will total £45 billion by 2026-27. On top of this (and more significantly), there is an energy support package that is expected to cost more than £100B over two years.
The intention was to help residents deal with higher energy prices and to boost growth via tax cuts and supply measures.
However, this fueled concerns that inflation and borrowing would surge at a time of already rapidly rising interest rates, triggering a cross-asset selloff so severe that it sent the pound to a record low.
Cue temporary mayhem.
But what happened - what were the mechanics behind such a sell-off and subsequent rebound?
Under the Radar
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2. Pension Funds 👉 Where Do They Fit In?
Typically, a large buyer of government debt is pension funds. Pension funds need to match the obligations they are required to pay out with the contributions they take in from the existing workforce.
Contributions taken in don’t just sit in a checking account, they are managed by fancy managers in order to earn a return in the process, leading to an over/under-funded status of each individual pension fund. This gives us:
A) Money in (from employee contributions)
+ B) Return on portfolio
- C) Money out (paying out those who retire)
= D) Funded Status (over/under-funded)
We’ll come back to this.
Due to the nature of future obligations that they need to pay out, pension funds typically target lower volatility returns and need a proportion of the portfolio to be invested in yield-generating products. That’s exactly what government debt is.
Pension funds in the UK own approximately £1.5 trillion ($1.65 trillion) in assets, and about 20% of these assets are held in direct gilts (the UK’s version of US Treasuries). As of this spring, pensions owned 28% of outstanding UK debt, weighted more towards the long end of the curve.
Let’s get back to the formula above. Because pension funds are valued by discounting their future liabilities (step C), the higher the interest rates are the lower their liabilities.
The acronym of the day is LDI (Liability Driven Investment) where pension funds calculate the duration of their future obligations and then hold fixed income assets that have the same duration.
The problem with this is that interest rates have been very low. This means that the liabilities that they held got larger while the fixed income securities they held (gilts) also had very low returns.
To make up for these vary low returns, they added leveraged LDI, buying bonds and interest rate derivatives (swaps). So the funds could have say, 30% of their portfolio in fixed income and put the rest into growth assets while claiming to be fully hedged.
Unfortunately, what they didn’t see coming was such a rapid move in interest rates.
Pension funds had a buffer to finance rates going up ~1.25%, but they were not prepared for what happened this year. The 25-year gilt spiked to 5.02% on Monday after being only 3.7% the week before.
When long-term interest rates jumped, one side of these swaps collapsed in value, forcing UK funds to post additional cash collateral. To do that the funds had to liquidate assets that they own outright.
The cause for the recent runup? As mentioned above - Truss' budget with its tax cuts and energy subsidies came out, adding to the BoE’s plan to increase its policy rate. Some speculated an inter-meeting hike would even have to come into place. So long-term interest rates spiked by 100 basis points and funds had to post more collateral immediately.
In a liquidity crisis, you sell what you can and in this case - it was government bonds.
This would’ve created a spiral whereby more and more collateral would be needed as rates further spiked, forcing more liquidation, causing a further spike in rates, and… you get the picture.
So in steps the BoE.
Before we continue, let’s check in with our Outrageous Chartered FinMEME Analyst Dr. Patel!
3. Monetary Response 👉 Using QE to Prevent Crisis
The BoE had to enforce an emergency intervention by pledging unlimited purchases of long-dated bonds.
They had to absorb the other side of the trade in this massive sell-off or else bond prices would’ve collapsed, further spiking yields.
The BoE kicked off the plan on Wednesday afternoon by purchasing just over £1 billion ($1.07 billion) of securities maturing in 20 years or more, less than the £5 billion it said it was prepared to buy at each auction. Operations will continue every weekday until Oct. 14, and after yesterday’s auction, we could see around £61B in buying.
This operation has so far worked, bringing yields back down during this wild swing:
There are two concerns here.
The first is the fragility of certain components of our financial system. Nothing works in isolation and markets may not be ready for such rapid moves in interest rates, especially systems that take a leveraged approach to LDI. Long-term rates affect everything from mortgages for individual consumers, all the way to the cost of borrowing for businesses which further stymies growth. This is a serious issue with far-reaching implications rather than just a blip on a Bloomberg screen.
The second issue is how intertwined and dependent upon each other fiscal and monetary policy have become. It’s clear the taxation and energy-focused bill from Truss rocked the bond market because of the narrative that it told. When narratives get out of hand and the free market takes over - it’s comforting to have monetary policy come to the rescue - but how often can this keep happening?
Until next time. Always Yours. Incessantly Chasing ROI,
-Genevieve Roch-Decter, CFA
What else we Grittin’ On?
POUND. Hedge funds piled into bullish pound contracts just ahead of its crash. Funds added over 13k long contracts last week.
15% TAX. The biggest companies will bear most of the burden from Biden's new 15% corporate minimum tax. Companies like Berkshire, Amazon, AT&T, eBay, and Moderna.
HARD-TO-TRADE. Cathie Wood launched a new venture fund offering access to hard-to-trade assets. The fund is open to all with a $500 minimum investment.
WHATSAPP. Several Wall Street firms were hit with fines totaling over $2 billion over improper communications on WhatsApp. A total of 12 banks received fines.
CONGRESS TRADES. The US House postponed its vote on a bill to ban Congress from trading stocks. That sound you just heard was Nancy Pelosi howling.
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