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How a blow up in the gilt market sent shudders through the system


Published: 21 Oct 2022

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We have been through the most extraordinary period of political, economic and market instability, including the replacement of a chancellor, Kwasi Kwarteng, after less than 40 days in office.

When the former chancellor Rishi Sunak – the first of 2022’s four chancellors (so far) - warned of an adverse market reaction if his leadership rival Liz Truss’s policies were implemented, even he could not have thought that things would take such dramatic turn. He surely would not have expected a replacement chancellor, Jeremy Hunt, to junk most of her tax-cutting agenda in response.

Financial crises in the UK have usually taken the form of sterling crises, such as the run-up to the November 1967 devaluation of the pound and, even more humiliatingly, sterling’s exit from the European exchange rate mechanism (ERM) on “Black Wednesday” in September 1992, when even all the UK’s foreign exchange reserves were not enough to save the day.

A crisis originating in the government bond market, the gilt market, is much more unusual. There was a “buyers’ strike” for gilts in the late 1970s when Denis Healey was chancellor, and one reason why the UK pioneered the use of index-linked gilts in the early 1980s was for fear that doubts about the country’s ability to get inflation down was making it harder to fund the budget deficit. Fears of an adverse gilt market reaction prompted David Cameron and George Osborne to embark on austerity after the 2010 election.

Though sterling did react badly to the former chancellor’s “plan for growth” fiscal event on September 23, subsequently falling to an all-time low against the dollar, the bigger and more worrying impact was in the gilt market. Large unfunded tax cuts and the absence of an assessment from the Office for Budget Responsibility (OBR) added up to a powerful sell signal for UK government bonds. So, even more, did Kwarteng’s immediate promise of further tax cuts to come and denials by ministers that there was any UK-specific problem. The irony was that the prime minister and then chancellor thought that the combination of the abolition of the 45% additional rate of tax and removing the cap on bankers’ bonuses would go down a storm in the markets, and in precisely the opposite way.

In September gilts had the worst month for the government bond market of any major economy for more than 60 years and the Bank of England was forced to step in with a temporary bond-buying programme of up to £65 billion when, in its words, the repricing of long-dated government debt posed “a material risk to financial stability”.

The Bank’s operation came to an end on October 14, at which point gilt yields remained significantly higher than they were before the September 23 “budget”, despite the removal of two of the planks of that statement, abolishing the 45% additional rate of tax and not proceeding with next April’s rise in corporation tax from 19% to 25%. The new chancellor, Jeremy Hunt, came under immediate pressure to go further, in raising tax and cutting public spending, than if the mini-maxi budget had never taken place.

The sell-off of gilts, traditionally the lowest risk assets, has had repercussions through the financial services sector. What looks like a bursting of the bond bubble has been feared for years. But few were prepared for it. The most obvious was the problem created for pension funds which had engaged in liability-driven investment (LDI). LDI, under which defined benefit funds use derivative products to meet their monthly obligations and match assets and liabilities, have been a popular and profitable product for asset managers, growing from £400 billion in 2011 to £1.6 trillion last year. Before the Bank’s intervention in the gilt market after the September 23 fiscal statement, the fear was of a “doom loop”, in which pension funds would need to sell gilts into a falling market to meet those obligations, threatening a further rise in yields.

Now there will be an inquest into the use of these products, whether it was prudent for pension funds to do so, and why the regulators were not more alive to such a potential threat to financial stability.

The second clear impact, of course, is on mortgage rates. It used to be the case that mortgage rates were closely linked to Bank Rate, the Bank of England’s key interest rate, which at time of writing is 2.25%. But in these days of predominantly fixed mortgage rates, it is the swap market, which is closely linked to gilt yields, which is the key determinant. The result of the gilt market fallout was that a typical two-year fixed mortgage saw its rate jump to more than 6%, up from 2.3% at the start of the year and 4.7% before Kwarteng’s announcements on September 23.

This is enormously challenging for the housing market, though Hunt’s massive U-trun provided a calming influence. An affordability model developed by Neal Hudson of Builtplace points to a mortgage rate of 6%-plus now being as big a real burden as 14% or 15% was in the late 1980s , because of the increase in typical homeowner debt. The one saving grace is that the effect is slower to come through than in the past, because only a proportion of people have to remortgage at any one time, roughly 300,000 a quarter.

Even so, banks, building societies and the Bank of England will be watching closely what happens to the housing market and the arguably even more vulnerable commercial property market.

Across the financial services industry, meanwhile, pension funds, insurance companies and other investors will be watching the gilt market. When the safest investment is as volatile as a cryptocurrency, we should all be concerned.