Sterling’s inescapable debt trap
Rising gilt yields will force chancellor Reeves’ hand before her autumn statement in end-September or early October. It’s a debt trap from which politics denies a solution.
ALASDAIR MACLEOD
The situation is so dire that some prescient economists are pointing out the dangers of a situation developing which mirrors the sterling crisis in 1976, when the IMF was called in.
This morning’s Sunday Telegraph headline was “Reeves heading for IMF bailout”, quoting the mounting concerns of several leading economists.
Clearly, things are hotting up, being the backdrop to the autumn statement.
In this article, I outline the situation for my paid subscribers, and why the comparison with 1976 is so apt.
But with other G7 nations in similar positions, I would question the ability of the IMF to bail Britain out this time.
In common with long-dated government bonds in other major currencies, long gilt yields continue to rise despite expectations of lower interest rates.
From the chart above, it is clear that there is sufficient bearish momentum in gilt prices to drive yields even higher.
It adds to the chancellor’s dilemma as she prepares her autumn statement for which a date has yet to be set but is expected in about 6—7 weeks’ time.
Debt interest is already a heavy and rising burden on her finances, as are the Treasury’s commitment to underwrite bond losses on the Bank of England’s balance sheet.
Will bond yields continue to rise before the autumn statement, even to the point of developing into a sterling crisis?
And what can Reeves do to stabilise the situation?
As Catherine McBride points out in her Substack posting, the UK is in a doom loop, whereby government activity stifles the economy leading to a debt spiral.
More specifically, virtually every element of Reeve’s first budget turns out to be counterproductive.
High earners and the wealthy are fleeing Britain rather than paying higher taxes.
The increase in minimum wages and employer’s rate of payment on national insurance, which is an additional cost on employment has resulted in job openings being cut and small businesses closing in droves.
Forget the statistics: Outside London, the economy is in a deepening recession.
And in London, shoplifting gangs operate, and tourists have their mobiles and watches stolen often at knifepoint, while police resources are tied up ensuring free speech is quashed.
The residential property market has ground to a halt, so anticipated capital gains tax receipts are not materialising: the list goes on.
Despite the evidence that higher and extra taxes result in lower revenue, further tax rises are expected to be announced in the autumn statement.
However, the Treasury will be acutely aware of tax shortfalls and of the additional expenses of higher salaries for government employees announced in Reeve’s first budget.
Clearly, if she attempts to cover a soaring budget deficit with yet higher taxes, she will end up with even less revenue.
Besides raiding peoples savings, the solution is to cut public spending, which she attempted and failed at the beginning of July.
The Parliamentary Labour Party refused to support welfare cuts, and clearly, spending ministers also refuse to accept departmental cuts.
She is cornered, which was evident in the emotional toll on her at Prime Minister’s Questions seven weeks ago.
As the gilt market begins to focus on the political and tax-raising impossibilities ahead of the autumn statement, dealers will surely conclude that the UK is indeed in a doom loop, with the budget soaring out of control and debt issuance with it.
And for those less focused on these issues, rising long bond yields in the other major currencies are a discouraging background.
Britain’s debt problem is exacerbated by high levels of foreign ownership of gilts, with hedge funds accounting for about 30% of gilts trading, borrowing £77bn in repos concentrating in a small number of funds, according to the Bank of England.
The bank has flagged concerns that forced liquidation by concentrated hands could lead to a market crisis.
These hedge funds might have a neutral sterling position, but their repo position means they are long of duration: in other words, they are financing long gilt positions by borrowing cash.
The fact that gilt prices are falling again will make these trades unprofitable, leading to the crisis expected by the Bank of England.
A debt crisis leads to interest rates that threaten to rise with no ceiling, in a repeat of the conditions seen during the last far-left labour government in the mid-seventies; a crisis which undermines the currency as well.
The 1976 sterling crisis
According to the Bank of England, in the 1975—1976 fiscal year to April, government debt increased by 21% and by 37% including the previous year (1973—1974).
The increase in 1975—1976 was nearly double the largest previous rise since 1958.
In April 1976, including central monetary institutions the Bank estimated foreign ownership of gilts and T-bills at 11.7% of the total.[i]
The deterioration in fiscal conditions was reflected in a growing run on sterling from mid-1975 onwards, as shown in the FRED chart above.
The cost of funding was already increasing, with coupons rising to new highs with the issue in December 1975 of 13 ¼% Treasury Loan 1997.
It should be noted that exchange controls existed at that time, which for UK residents meant no escape from sterling weakness without paying a hefty dollar premium.
Selling was down to international holders of gilts, foreign banks based in London and multinational corporations with sterling balances.
Repo markets did not exist at that time which meant that currency speculation and interest rate arbitrage were not as significant factors as they are today.
The sterling crisis was obviously driven by the government’s debt crisis, leading to a run on the Bank’s foreign reserves, and the loss of international confidence in the government’s policies.
Against this deteriorating background, domestic institutions refused to buy gilts, and in October 1976, the bank raised interest rates to 15% but institutions still refused to buy.
In a panic, Britain applied to the IMF for a $3.9bn (£2.25bn) loan at end-September.
In November, an IMF delegation arrived secretly to assess and negotiate terms.
Consequently, the government had to abandon its socialist shibboleths and restore the nation’s finances.
The IMF’s medicine worked, and then Britain had a stroke of luck.
In 1976, North Sea oil production began to be profitable, with major fields such as Brent and Forties coming on stream.
Sterling went from basket case to petro-currency, and sterling recovered all of its losses by the end of the decade.
Today, there are differences compared with 1975—1976, but the problems are similar, with a far-left government unable to cut public spending while penalising the tax base.
The only solution was outside discipline in the form of the IMF insisting on preconditions for its loan.
And today, sterling has yet to reflect what is clearly a forthcoming funding crisis.
There are no exchange controls today, so not only will foreign owners of sterling be exposed, but UK hedge funds and even less speculating institutions are likely to be sellers.
The bear’s prize could well be to see sterling drop to test the all-time lows at $1.05—$1.10, first seen in February 1985 when it hit $1.04 driven by a strong dollar, and again in September 2022 for the same reason.
Today, the dollar is weak as well, so sterling returning to those levels, like in 1976, would be entirely due to a sterling crisis.
And even if the gold/dollar rate holds at $3350, that would take gold in sterling to £3200.
However, the dollar itself is falling relative to gold so in the coming months the sterling/gold rate could be significantly higher.
Gold is almost certainly the best escape from the UK’s rapidly developing funding and sterling crisis.
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[i] See Bank of England’s Q4 quarterly bulletin, 1976
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