Summary
How is it that within the space of a few weeks Kwasi Kwarteng was as unceremoniously sacked as Greek Gianis Varoufakis in 2015, and Liz Truss’s position is as, if not more, precarious than Silvio Berlusconi’s in 2012? The answer is really not that surprising: It’s Quantitative Tightening meeting political moral hazard.
We are seeing the worst bond market volatility in decades. And when extreme volatility is met by the false assumption that markets can be ignored or even worse, that they ‘need to be taught a lesson’, catastrophe looms.
With QE in reverse, the irony is hard to miss. In 2008, politicians were afraid of financial moral hazard. In 2022, it is the financial system that worries about political moral hazard.
Yet Mr Kwarteng is hardly the first person who entertained the notion that market volatility can be ignored. His transgression, in fact, is probably dwarfed by the present Fed’s belief that it can ignore market volatility in its fight against inflation.
Sharp market reactions to policy decisions, show that they are not Pavlov’s dogs. They are, for lack of a better simile, Pavlov’s very angry Grizzly bears.
The lesson from Mr Kwarteng’s short reign is that policy makers need to quickly embrace the fact that this is not a good time to test markets. A lesson that the Bank of England may also soon learn, if it refuses to proceed with more QE should conditions warrant it. Or even the Fed if it fails to signal an eventual return to accommodation.
As for the UK?
It will take patience for the damage to be undone. Announcing a U-turn in terms of taxes, and even raising them could prove too little to appease markets. In the past, the solution has come through general elections, technocratic governments etc. The final terms and conditions of Brexit will also play a pivotal role in reducing volatility.
Having a country’s sovereign debt on the front page of every financial news outlet on the planet is never a good thing. Greece and Italy found that out a decade ago. The Euro crisis demolished incumbent leaderships, cost years of austerity and lacklustre growth and, to this day, paints a bull’s eye on their backs every time there’s notable market volatility.
With the UK, however, things ought to be different. The country features a comfortable 87% government debt-to-GDP, below the 91% global average and significantly lower than the 140%-plus for Greece and Italy. The economy has firm roots in big sectors like finance, exports, technology, healthcare and logistics. And unlike the two Eurozone nations, it has complete liberty to print its own money. In a monetary world, monetary independence is important. It means that a country can always print money to pay off what it owes- even at the cost of a weaker currency.
So how has it come to this? How is it that within the space of a few weeks Kwasi Kwarteng was as unceremoniously sacked as Greek Gianis Varoufakis in 2015, and Liz Truss’s position is as, if not more, precarious than Silvio Berlusconi’s in 2012?
The answer is really not that surprising: It’s Quantitative Tightening meeting political moral hazard.
Central banks monopolised bond markets for more than a decade. Bond trading desks were closed, especially banking ones, as purchases were dominated by central bank buying and risks were drastically curtailed by regulators. As a result, there are now less buyers to purchase at lower prices. Central banks, led by the Fed, also led equity markets with powerful signals, refusing to let markets drop significantly.
The end of Quantitative Easing, a nearly ubiquitous financial paradigm, is now breaking things. We are seeing the worst bond market volatility in decades. The bond market is much thinner and volatility much higher than even 2008. Never in recent history have equities and bonds dropped in near-perfect correlation, and so much. These are not just risk assets for the wealthy. They represent the only two ways companies can receive financing from functioning markets.
And when extreme volatility is met by the false assumption that markets can be ignored or even worse, that they ‘need to be taught a lesson’, catastrophe looms.
2008, was all about the moral hazard created by the financial industry. Banks were thereafter shackled and risk was transferred to private, non-systemic investors, like asset managers and private equity funds.
However, one of the major side-effects of Quantitative Easing was that political leaders in the recent past were not hit by markets when they made decisions. Anytime there was a hint of market volatility, the Fed would intervene and quash it. For fourteen years, quantitative easing covered all manner of global political sin. Sedated markets bought governments’ time, in bundles.
Quantitative Easing turned to Quantitative Tightening and the logic was reversed. As QE was a signal to decision makers that they can take risks, QT signals that they should lock their liquidity and avoid them altogether. One hundred billion of QT could mean many times that amount in liquidity withdrawn from markets.
In fact, now that QE has gone in reverse, the irony is hard to miss. In 2008, politicians were afraid of financial moral hazard. In 2022, it is the financial system that worries about political moral hazard. It’s difficult for many to understand that the QE safety net not only does not exist, but that what lies below the tightrope is, in fact, a spiked pit.
Yet Mr Kwarteng is hardly the first person who entertained the notion that market volatility can be ignored. Alastair Darling did the same when he prevented Barclays from buying Lehman Brothers, letting the latter fail in 2008. Republican candidate John McCain also did that, when he obstructed Congress from releasing money to the financial system shortly after. So did Secretary of Treasury Andrew Mellon in 1929, when he, and other ‘liquidators’ felt that it was best to let weak institutions fail.
Mr Kwarteng’s transgression, in fact, is probably dwarfed by the present Fed’s belief that it can ignore market volatility in its fight against inflation. For years we have said that markets were behaving like Pavlov’s dogs, responding to the Fed’s stimulus. This may have been the case when markets were going up. But when bond markets are collapsing, we find that the metaphor is no longer useful. Markets are big and deep and can run wild. They are the bedrock of capitalism, not central banks. They can react much faster to events and challenges than any political body can decide on how to respond to them.
And the only thing that traders are truly afraid of is (monetary) bazookas. If one wants to influence them, it can only be done through bribery and appeasement. No single institution, economic or political is the market’s master. They are not Pavlov’s dogs. They are, for lack of a better simile, Pavlov’s very angry Grizzly bears. And they are locked in the same cage as policy makers – a cage made by pension systems and international financing. Market volatility almost wrecked British pensions two weeks ago. No government or institution could survive this.
The lesson from Mr Kwarteng’s short reign is that policy makers need to quickly embrace the fact that this is not a good time to test markets. A lesson that the Bank of England may also soon learn, if it refuses to proceed with more QE should conditions warrant it. Or even the Fed if it fails to signal an eventual return to accommodation.
‘Bond vigilantes’ have re-appeared after a decade, and they will test systemic weaknesses; be that the idea of economic sovereignty in an intertwined world, decentralised finance, the strength of a common currency shared by very different economies, or the ability of central banks to fight supply-side inflation, with below-inflation interest rates.
We believe that it is difficult for central banks to withstand a convulsing bond market. The ‘Fed Pivot’, the return to monetary accommodation, will not happen as part of a strategic planning, but as a necessity, similar to the one that prompted sharp rate hikes to begin with. This may be facilitated by rising unemployment or slightly lower inflation, but it could also happen much quicker.
This volatility that we are experiencing is what investors and portfolio managers were hoping for, as means of returning to an easier monetary regime.
As for the UK?
It will take patience for the damage to be undone. Announcing a U-turn in terms of taxes, and even raising them could prove too little to appease markets. In the past, the solution has come through general elections, technocratic governments etc. The final terms and conditions of Brexit will also play a pivotal role in reducing volatility.
Having said that, we believe that the UK is in a much stronger position that Greece or Italy. It has much lower debt, a broader economy and a great track record in keeping spending from getting out of control. For lack of a better word, it has ‘street credibility’, accumulated investor goodwill. There is damage for sure, but if British governments exhibit prudence and willingness to reconcile with their largest trading partners, we think that this damage can be reversed.
