Four weeks ago, just as the BBC was telling the world that the pound was falling because ‘the markets’ didn’t like Liz Truss’s economic policy, some financial genius apparently made a fortune buying the pound at $1.03 to the US dollar – perhaps they were looking at the fundamentals rather than listening to the BBC. Of course, currencies aren’t traded on an exchange but as spreads between banks and brokers, so it is hard to know what quantity traded at this level. Even still the Government decided to pander to the opinions of the foolish sellers who sold at $1.03 rather than trust the instincts of the wise buyers.
Markets are never one sided, they just show us which side is less sensitive to price, or less able to wait or sometimes simply who is the cannier trader. But if the fundamentals haven’t changed, the price move won’t last long.
A good example of sellers unable to wait would be some UK pension funds, generally considered to be long term investors, yet they were scrambling to sell government bonds four weeks ago even though bonds are redeemable at par on maturity. The pension funds needed to make cash margin calls on their Liability Driven Investment derivatives when bond prices dropped quickly on the back of Bank of England selling coupled with the debt forecast to be required to pay for the mini-budget and exacerbated by the pension fund’s own selling.
Few have questioned why pension funds are involved in complex derivative trades at all, but it stems from a requirement to hold government debt paying ultra-low interest rates for over a decade; low dividend yields due to equity prices inflated by ultra-low interest rates; the loss of dividend tax exemptions for pensions funds; yet being required to pay pensions linked to inflation or final salaries. The solution was to swap the pension’s variable returns for fixed returns that matched their liabilities – LDIs. The problem was LDI swaps cleared through central counterparties, as recommended by the Financial Stability Board, require cash margin calls, so as rates increased funds had to sell illiquid long dated bonds to raise cash.
The media also failed to ask why the Pension Funds were unready for bond price falls after the Bank of England had announced that they would sell £80 billion of their stock of Government Bonds over the next 12 months ‘in line with the strategy set out in the minutes of the August MPC meeting.’ This shouldn’t have been a surprise to the pension funds. The Bank of England, holder of over £800 billion Government Bonds, had given them a month’s warning it was planning to sell about 10% of its holdings, but somehow, they failed to notice. So, the Bank was forced to flip its bond sales into purchases to provide the pension funds with cash for their margin calls.
These transactions were interpreted by media commentators to suit their political opinion and so the Bank of England’s bond purchases were described in the press as an effort to ‘support the pound’ rather than ‘necessary to support some pension funds’.
Pricing the unknown
At best, investors’ trades are based on their estimates of future costs, or future earnings, or the possible effect of international events and rarely on known quantities. (Which in some markets would be considered insider trading.)
An example of this would be Liz Truss’s ‘unfunded’ energy package which had the potential to be an enormous cost to taxpayers, but it was not a surprise to the markets as it had been announced weeks before. When the energy cap was first proposed some estimates claimed it would cost £160 billion causing gilts to fall. However, by the time the cap was formally announced estimates suggested the cost would be more like £65 billion, later this was revised down to £40 billion, by Thursday only £35 billion as gas prices have fallen significantly since the summer. If gas prices fall further – the final cost may be nothing. This caused Gilt prices to rise a little on Thursday, but the credit was not given to falling gas prices nor was the mini-budget reprieved.
Unfortunately, the damage had been done. Truss’s political opponents had blamed her budget for the gilt fall and removed her Chancellor from office. Then, Truss herself was removed and rather ironically replaced by the person most responsible for the UK’s inflation, having increased the money supply by £500 billion in two years whilst he was Chancellor. Interestingly Gilts suffered a much larger fall in July 2020 than after the mini-budget but I don’t remember complaints about this from the media’s market interpreters. Just as they didn’t blame Truss’s energy package for the fall in bond prices but laid the blame on her tax cuts. This was probably because Labour, as well as other EU countries, were proposing similar energy subsidies.
Hostage to fortune
Now, the Media are trying to convince us that the pound has increased to $1.15 because Sunak was installed as Prime Minister, yet they are studiously ignoring that while he was Chancellor it dropped from $1.30 to $1.20. Should we conclude that the market thought he was a rubbish Chancellor but might be an OK Prime Minister?
Pinning market movements on a Prime Minister’s appointment is a hostage to fortune: Although the Bank of England is expected to increase interest rates by 50 to 75 basis points at its next meeting on November 3rd, this is unlikely to narrow the interest rate differential between the UK and the US. The US Federal Reserve meets the day before and is also expected to increase rates by 75 basis points and do the same again in mid-December.
The Deputy Governor of the Bank of England, Ben Broadbent, apparently hinted last week that he expects UK rates would peak at 3% next spring implying financial market participants were pricing in too many future increases in the Bank rate. (So much for media commentators’ belief in market infallibility.) However, if true, and if the US acts as expected, then the US/UK rate differential will widen further, encouraging more investors to buy dollars regardless of who’s the UK Prime Minister. So, if it suits the media’s agenda, Sunak’s honeymoon period maybe short.
On the other hand, the lower gas price and warm windy autumn weather has given UK households some temporary relief from high energy bills so the Bank of England may feel entitled to soak up this extra cash with a higher than expected interest rate increase. The UK’s high energy bills were doing the work of higher interest rates during the summer – absorbing some of the money Sunak had printed during lockdown. But lower gas prices are a temporary financial relief – winter is still coming, so the Bank will probably only increase rates as expected.
The other side of the pond
Alternatively, there is always a chance that US rates may not be increased by 75 basis points in both November and December, which would steady the interest rate differentials and relative currency values between the US and the rest of the developed world. Although US retail prices are still rising, the bottlenecks in consumer goods caused by the global lockdowns are being fixed and could quickly turn into product gluts, leading to retailer discounting, which in turn will lower core inflation. So, the Federal Reserve may skip the December rate increase to avoid a recession.
However, there would still be lots of other reasons to buy dollars even if without more interest rate rises: most obviously in order to buy US equities, bonds or real estate; or to buy dollar denominated commodities; or because the dollar is a safe haven during unsettled geopolitical times; or because they expect the Republicans to take back the house in the mid-term elections and introduce some supply side reforms. But for every buyer there will also be a seller with just as valid reasons: maybe they want to buy non-dollar assets while they’re cheap; or maybe they are worried by the amount of money the US is printing; or maybe they’re troubled by a Republican controlled House under a Democrat presidency.
government intervention can increase prices
It is still possible for Government policies to cause long-term price changes. When Rishi Sunak became chancellor in February 2020, the UK gas price was about 20p per therm, when he resigned on the 5th of July it was 294p per therm, having been as high as 539p in March and it would later go to 643p in August.
The increased gas price is due to several UK Government policies: closing UK gas storage sites; banning fracking; not approving new North Sea gas developments; applying 6 monthly price caps to domestic energy bills; legislating that the UK must dramatically reduce its carbon emissions despite the economy’s dependence on gas as both an energy source and an industrial input; and finally Chancellor Sunak adding a further 25% tax to UK oil and gas companies, making their total tax rate 65% and thus completely disincentivising them from increasing their UK production. Is there any wonder that UK wholesale gas users were prepared to pay any price for gas when Putin turned off the Nord Stream pipeline this summer?
Unbelievably, Sunak thought his first week in office would be a good time to announce that he will reintroduce a ban on fracking in the UK that Liz Truss had announced would be removed. The UK imports natural gas that has been fracked in other countries, liquefied and transported thousands of miles to the UK before being re-gasified and used to heat UK houses and make electricity but somehow this is better for the environment than using our own gas… International energy speculators must be piling into natural gas futures as I write, unless they suspect Sunak or the EU is also planning to capitulate to Putin in which case they’re probably selling.
The Government’s energy policies caused this short squeeze and therefore it could be considered appropriate for the Government to offer to subsidise everyone’s energy bills, as a collective government mea culpa – despite the potentially massive ‘un-funded’ cost. It would have been preferable and simpler for the Government to remove the VAT and levies they add to energy prices. It is obnoxious to create the conditions for a massive price squeeze of an essential commodity, but it is repugnant to add taxes on top of that already bloated price.
So who is really talking?
To conclude, the talking heads should not blame UK currency movements on the new (unelected) Prime Minister – those have been and will be caused by the decisions of the Bank of England relative to other Central Banks, although it could be argued that the Bank of England’s decisions are based on economic policy outcomes. But the talking heads should blame any increases in consumers’ and businesses’ energy bills on Sunak and his Government’s policies. Although somehow, I doubt that they will.
After all, if commentators can blame anything on ‘the markets’ which don’t talk and cannot answer back, they can frame the narrative in any way which suits their own agenda. This is a very powerful ventriloquist act.