Dr. No (bid)
This has been an eventful week for the Bank of England (BoE).
To stay in tune with a very British event, I will try to stick to James Bond references throughout the article. I love the franchise, and I will not lose the occasion as I for once talk about “Bond”.
Also, as a Frenchman by birth and education, I cannot NOT poke fun at the British.
To make it short, the government came up with a magnificent plan to spend hundreds of billions of pounds to buffer energy price rises. This was in response to the message of Russia not feeling like providing power and heating to countries arming Ukraine against it.
To finance that, it went to the tried and tested method of emitting more debt. The problem is that apparently, no one wanted to buy it. In financial jargon, it went “no bid”.
So interest rates on the British bond went up and up and up.
This triggered something interesting, which I doubt is specifically British. It went that way:
The more rates went up, the more bond value went down.
The lower bond prices went, the larger the margin calls for bondholders.
When margin calls became too high, some pension funds HAD to sell at any price the bonds they were holding.
The selling made rates go up even more.
This triggered more margin calls.
Hence more selling.
Hence more increase in rates.
… Rinse and repeat until the entire UK pension system (and probably a few banks and other funds) go belly up.
This “doom loop” got interrupted at the last minute by the BoE.
(To understand better the way bonds are priced, I recommend reading “Bond of mass destruction”. )
What it did was, in practice, print money to buy “a limitless number of targeted government bonds”. For now £65B, but probably much more over time. This is not solving the problem, just postponing it.
I am simplifying, of course, there is actual technical detail in this business, like swap lines, etc... But really this is what it boiled down to. And getting lost in the detail can distract from the main point.
This has not only stirred, but shaken the financial world, with comparison to a “Lehman moment” similar to the trigger of the 2008 crash.
Profit-free risk bonds
You might ask, how did we get there?
Well, central banks started to manipulate rates a long while ago. We were told it could go on endlessly, the way diamonds are forever.
And for a while it did.
Government bonds started to give 0% or even negative interest rates.
“Give $1000 to the government, and get $950 back a decade later.”
You might wonder who is stupid enough to take that deal, right? Well, pension funds for once. They are by law (laws voted by the same government selling said bonds) to buy only “safe” assets. This includes AAA-rated bonds.
I remember, 3 years ago, a friend told me he know a pension money manager that is forced to buy negative interest rate bonds instead of keeping cash. Somehow, the law said that GUARANTEED losses on cash are safer than keeping cash un-invested.
Go figure.
Controlling inflation
The party stopped when inflation became a problem. The known method to control inflation is to rein in the money supply by rising interest rates.
Central banks around the world told us they were REAL SERIOUS about fighting inflation. No amount of financial market (or pension fund) crashes would block them from doing what they had to do.
Powel and his fellow central bankers were the men with the golden guns that would slaughter inflation.
They meant it, never doubt it one second…
Tomorrow, when the pain would be too much and central banks change their tune, would never happen.
But tomorrow never dies.
The BoE is the first central bank to blink, but certainly not the last.
When it comes to it, no one wants to be accused to have let a 1929 crash-style happen.
They blinked and everybody knows it.
License to kill (the currency)
When it comes to large monetary stuff like this one, it is easy to get confused.
Looking at emerging markets makes it a lot clearer. They are REGULARLY having debt and/or currency crises. It always ends up in 2 ways.
1/ They either cannot keep paying public spending or default on the existing debt, an option the BoE could evidently not accept.
To see what it looks like, give a glance at Sri Lanka, running out of food and fuel
2/ Or they kill their currency in a desperate tentative to delay the inevitable.
The BoE just got given such a license to kill the pound sterling.
Technically it could end up in a third way. Willingly reduce public spending now, renegotiate the debt and live within your means forever after. This happens so rarely that it is barely worth mentioning. I see no intent of doing so anywhere in Europe.
As the bond yields are now “saved” through money printing, the pressure valve is the pound sterling.
It briefly went close to parity with the USD before rebounding at it. But this is really just the last leg of a slow, steady decline from £1.7 per 1 USD in 2014.
What now?
For a little while, the tumult of the pound, British bonds, and the BoE are probably going to go away.
Nevertheless, we are now reaching the time to suffer the consequence of central banks having turned financial markets into an endless Casino Royal.
The Spectre of inflation looms over Europe, and will not go away anytime soon.
Usually, totally out-of-control inflation comes from the destruction of productive capacity through war.
The combination of limitless money printing and loss of productive capacity is how you get high inflation or even hyperinflation.
Incredibly, we might get there BEFORE a real war this time, as it seems economic war with Russia is enough to collapse the excessively indebted Western European economies. Limitless money printing during COVID seems to have play the same role as war-time money printing.
So the individual solutions against such inflation/stagflation are the same as always:
Avoiding variable rate debt.
Taking more fixed debt if you can buy productive assets with it.
Own real assets, like commodities, energy, and real estate, over financial instruments and consumer goods companies.
Increase personal resilience with a good stock of consumables.
Some amount of precious metals and other stores of value (art, land, maybe even crypto).
I hope this was a little informative and entertaining.
I sure had fun spinning everything around James Bond references and making this topic a little less dry.
(Lastly, credit where credit is due, it was Lyn Alden that first made me realize Europe was going to react the same way as an emerging country, in an excellent 2019 piece. )