Is the UK in a Sovereign Debt Crisis?

The dramatic political reaction to former Chancellor Kwasi Kwarteng’s ‘fiscal event’ on 23 September was entirely predictable. Less predictable, however, was the scale of the fallout in the UK’s sovereign bond market.

 Yields on gilts of every maturity jumped frenetically, with 10-year and 30-year borrowing rates rising by 0.7 and over 1 percentage points, respectively, in the wake of the announcements. The size of these moves led many financial and economic commentators to interpret them as a sign that asset managers and capital markets more generally were losing faith in the British government’s ability or inclination to continue paying its debt.

 This view held that the size of Downing Street’s tax cuts – combined with the lack of any corresponding spending reductions, the existing borrowing commitments and the hollowness of the government’s growth strategy – had prompted investors to seriously reassess the default risk of UK government bonds. 

Other observers, like Steven Major, head of fixed income research at HSBC, writes that the spike in yields was “not because there are serious questions about the creditworthiness of the UK government.”

 Because the UK’s underlying borrowing capacity depends on a range of deeply uncertain factors, it is impossible to say with certainty whether perceived default risk is part of what initially drove investors to revalue UK debt. However, a key data point, as Bank of England veteran and National Institute of Economic and Social Research president Paul Tucker noted, is the change in the spread between yields on nominal and inflation-indexed or real bonds. Or rather, the lack of any discernible change.

 For an investor to forgo protection from the possibility of unanticipated inflation eroding the real value of their bond before it reaches maturity, they’ll insist on a higher rate of return. This makes the gap between nominal and real yields a reliable measure of the bond market’s inflation expectations.

 Under conventional assumptions about productivity growth, demographics and interest rates, the current path of UK fiscal policy is unsustainable over the long run. This makes a future debt default distinctly possible. Such a scenario would take one of two forms.

 First, a future government might engage in a legal default, meaning it officially refuses to comply with the terms it agreed to when it initially issued its debts. Second, it could force the Bank of England to break from its 2% inflation mandate and engineer a period of unexpectedly rapid inflation, reducing the real value of the government’s liabilities and thereby transferring resources from bondholders to taxpayers.

 This scenario, sometimes known as an economic or inflationary default, involves ‘fiscal dominance’, wherein monetary objectives become subordinate to fiscal objectives. It occurs when the debt-to-GDP ratio grows large enough that two of the government’s core macroeconomic objectives – low inflation, i.e. stability in the value of government liabilities, and debt sustainability, i.e. full nominal repayment of those liabilities – are no longer compatible.

 The legal route is likely to be messier, more abrupt and significantly more damaging to the UK’s long-term economic prospects. As a result, a future government is much more likely to opt for the inflationary route. The implication is that if investors begin to lose faith in the treasury’s credit-worthiness, the initial signal will be a rise in inflation expectations.

 An investor demanding a default-risk premium on nominal bonds without simultaneously raising their inflation expectations is one expressing near certainty that a future government would opt for the more economically and politically costly type of default. Such investors might well exist, given the recent rise in UK sovereign credit default swap rates, but they are rare.

 Another important data point is the nature and effect of the intervention launched by the Bank of England on 28 September. For many, unconventional monetary policy operations, as Ricardo Reis puts it, possess a certain mystique. Central banks are sometimes seen as a sort of angel investor, able to draw on separate and perhaps deeper pockets than other parts of the government.

Central bankers have been in no rush to dispel this perception, and most of the time it’s not relevant. But when financial markets suddenly seize up, it can obscure the underlying accounting. Put simply, when a government’s borrowing costs rise because of an increase in perceived default risk, its central bank can’t ‘bail-out’ its treasury. The government’s budget constraint jointly limits both institutions’ financial capabilities; the central bank can purchase the treasury’s debt, but the Monetary Policy Committee borrows from commercial banks to fund these operations, by issuing interest-bearing reserves.

 This matters, of course, because in a situation where a spike in bond yields reflects larger default risk, the Bank of England couldn’t reduce that risk simply by buying more of them. The only way to reduce default risk is for the treasury to succeed in altering market expectations about the size of future expenditures relative to tax revenues.

 In the eurozone the European Central Bank represents member states collectively, and so its asset purchases can affect an individual member state’s default risk. But in a country like the UK with its own central bank, although the average maturity is important, the division of liabilities between the treasury and the central bank is irrelevant for debt dynamics. 

 Now, when the Bank of England announced its willingness to purchase long-term bonds on September 28, its role was that of a market-maker of last resort, as Walter Bagehot famously advocated in the mid 19th century. When the news broke, the reason yields immediately fell was that the spike was being greatly amplified by a serious liquidity shortage on the part of some of the largest holders of UK bonds.

 The FT has some great reporting on this, but simplifying a little, the basic issue is that the pension fund sector relies on a pile of interest rate swaps to hedge against the risk that falling interest rates would raise the present value of their mostly long-term liabilities over their assets, some of which are much less sensitive to rate changes.

 The former Chancellor’s announcements on 23 September raised market expectations about the path of the Bank of England’s policy rate due to higher expected aggregate demand, and more importantly, injected a lot of uncertainty into the trajectory of fiscal policy.

 The ensuing rise in yields meant that pension schemes had to keep their swap positions collateralised, in the case of those operating through centralised clearing houses, using cash. To generate it, schemes began selling gilts. 

Because the wave of selling was both sudden and sector-wide, this rapidly drove prices further down, which meant more collateral had to be posted, necessitating more selling. Liability-driven investment (LDI) strategies are nothing new, but their fragility pushed much of the UK’s pension industry into a doom loop, hugely amplifying the initial spike in yields.

Meanwhile, the widening of the bid-ask spread eroded some of the liquidity or ‘convenience yield’ on UK bonds, a significant factor behind many investor’s appetite for sovereign debt.

So, while the Bank of England’s offer was simply to swap one form of government liability for another, cash was what the pension sector needed to meet its margin calls.

Of course, a no less striking feature of the market reaction was the fall in sterling’s exchange rate against both a generally buoyant dollar and against the euro. Rising interest rate expectations, in isolation, would have appreciated the pound, but that effect was overwhelmed by the enormous uncertainty that the former Chancellor’s announcements had injected into fiscal and therefore monetary policy, sparking a flight into foreign currencies.

Other aspects of the market shifts since 23 September remain somewhat mysterious. The gap that has opened up between long-run government bond yields and long-run OIS forward rates, for example, has not yet been explained. Overall, however, from an investor’s perspective, the key thing the new Chancellor has to ‘deliver’ in his expedited announcements is concrete forward guidance on the trajectory of fiscal policy.