The UK Canary in the Coal Mine

3 October 2022

Bond markets may yet force Powell’s foot from our financial windpipe, and the mighty dollar is not so invincible.

We are not alone

The main topic in the past couple of weeks has been disorder and interventions in developed market currencies and sovereign bonds. Specifically, Japan implemented its first currency intervention in two decades, and the British pound had its biggest single-day fall in history in response to its (not so) mini-budget. The Bank of England resumed purchases of long-duration UK sovereign bonds despite high inflation to temporarily rescue insolvent pension funds and restore financial stability. Bond yields across the developed world, including the US, had unusually volatile moves with increasingly constrained levels of liquidity and growing signs of market stress.

Our currency, your problem

The common denominator of these events has been the tightening of US monetary policy. The Federal Reserve has attempted to create unemployment and reduce demand-led price inflation. In so doing, the US has been ahead of the rest of the developed world. The notable laggards have been Japan and the Eurozone due to their high debt-to-GDP ratios and demographically challenged growth outlooks. A combined hawkish Fed with the energy-led balance of payments crises in Japan and Europe has led to an exceptionally strong US dollar. Which, on most measures of purchasing power parity, is now overvalued.

Pressure builds

The US won’t have it all its own way forever. The US $ is the world’s primary global trading currency, lending currency and reserve asset. The surging value of the dollar hardens the liabilities of foreign entities, including central banks, financial institutions and large corporates. As the pressure builds, such entities stop buying and ultimately sell their US dollar assets, mainly US Treasuries, to support their currencies and domestic bond yields and make payments for essentials like energy. Japan has started this process by selling $20bn of US treasuries to support the yen. Reports suggest China could follow suit. Both have plenty more dollar assets in reserve.

Buyers turn seller

But already, there are early signs of illiquidity in the US Treasury market. Just when the Federal Reserve plans to move into a round of Quantitative Tightening (QT) and sell bonds, its reliable buyers have turned into sellers. They could become forced sellers. While the US has other measures to employ, such as increasing the banks’ Supplementary Leverage Ratio (SLR), they are running out of people to buy their bonds. The very scenario that hit the UK gilt market last week.

QT to QE

The Liability Driven Investment strategies of the UK’s large pension funds were insufficiently solvent to pay margin calls on their portfolios of UK government debt. The last reliable institutional buyer of gilts turned seller, forcing the BofE’s hand to provide liquidity. It was imperative to save the foundational asset of the UK mortgage market and other long-duration assets, including civil servants’ pension plans. But at the same time, it raised the alarm around the thorny issue of central bank independence. The Bank of England has joined the Bank of Japan, the Peoples Bank of China and the ECB in “temporarily” monetising its government’s debt. But, note the adage that “nothing is as permanent as a temporary government policy”.

Our bond market, our problem

However, it’s not until the US Federal Reserve resorts to some liquidity program on US Treasuries that this cycle really changes. While most investors have been watching for real economy breakages as the proximate cause for the Fed to pivot, it is now more likely that the signal will come from the US Treasury market. The BIS estimates that the US Treasury market functionality is at the worst level seen since 2020 and at similarly distressed levels as 2008. In other words, with the current tightening, there is a good chance that the US Treasury market or adjacent markets (credit or pension funds) will run into acute liquidity problems before inflation is back to 2% and even before unemployment increases significantly.

Safest haven

Precisely this scenario represents Jay Powell’s worst nightmare and is why he is determined not to prematurely take his foot off the world’s financial windpipe until he absolutely must. He sees himself as more Paul Volcker than Arthur Burns. However, markets may yet force his hand, or foot even. The big question is whether any such forced loosening starts another round of inflation. If it does, US dollar weakness then turns into a rout, and precious metals (other real assets are available) can yet become investors’ safest haven.

Written by Jeremy McKeown