The Lesson from the U.K. Budget Meltdown: Fear Currencies, Not Bond Markets
The Bank of England’s gilt-market intervention underlines how governments can always borrow more
By Jon Sindreu
The U.K. is a large economy with deep capital markets and a widely-owned currency, fears of an unstoppable slide in the pound seem overblown. / PHOTO: FRANK AUGSTEIN/ASSOCIATED PRESSJames Carville should have wished he could be the currency market.
The famous 1994 remark by Bill Clinton’s political adviser that he would like to be reincarnated as the bond market encapsulates a widespread perception among investors and officials that, when currencies are left to float freely, soaring public debt becomes the key constraint on government spending.
The U.K.’s budget crisis shows why they are wrong.
On Wednesday, the Bank of England stepped in to stop a big selloff in U.K. debt caused by the government announcing a fiscal package that could cost a whopping £291 billion ($312 billion) for little obvious economic gain.
In a complete U-turn from its plan to sell bonds in an effort to tamp down inflation, the central bank said it would instead buy long-dated gilts.
Yields quickly dropped.
There is nothing new about this intervention.
The BOE was created in 1694 to finance a war against France, and managing public debt has been a core job of all central banks since.
As much as central bankers refuse to admit it openly, they must intervene whenever sovereign-bond yields get out of whack with interest rates.
It is what UWE Bristol Professor Daniela Gabor has dubbed “prudential monetary financing”: The BOE acted because bond volatility risked torpedoing Britain’s massive pension-fund industry, which matches its long-term liabilities with long-maturity debt and derivatives.
The haven role of government paper means that its stability must be preserved at all costs, or it would be impossible to set interest rates for households and businesses.
Budding “bond vigilantes” shouldn’t make the mistake of thinking they can bet against a central bank which can buy an infinite amount of debt.
Yet, despite the BOE’s announcement, shorter-maturity yields remain quite high.
Why?
Mostly because officials have heavily implied that, even if the market absorbs the bonds necessary to fund Britain’s borrowing binge, rates will need to rise faster to stop the recent fall in sterling.
This shows where a country’s true vulnerability lies: its currency.
After President Nixon killed the Bretton Woods system of pegged currencies in 1971, the world slowly embraced floating exchange rates.
For rich nations, these have been successful shock absorbers, preventing traditional balance-of-payments crises in moments of turmoil such as the Brexit referendum in 2016.
Even today’s big currency depreciations in emerging economies such as South Korea are proving far less damaging than they were during the 1997 Asian Financial Crisis.
Constraints for governments are soft under this system, but they still exist—a harsh reality that Turkey has experienced in recent years.
A falling currency raises the cost of imports, a big issue during today’s energy crisis, and can lead to inflationary spirals that make it hard to predict how high rates need to go.
Many British banks pulled mortgage products this week, fearing they wouldn’t be able to hedge them properly.
Raising rates to defend the exchange rate can push an economy into a deep recession.
While 83% of U.K. mortgages have fixed rates, the fixed term on a majority of them isn’t longer than five years.
For those with two-year terms, current market pricing would mean paying an extra £500 a month, equivalent to $543, in September 2023, Capital Economics estimates.
Investors might benefit from studying the potential exchange-rate impact of fiscal policies more than the usual borrowing metrics.
The refusal of central banks in open Western economies such as the U.K., Canada and Australia to acknowledge the need to manage their currencies in a worst-case scenario has left them with gross foreign reserves below 8% of their annual output.
Japan, a free-floating but more interventionist nation, has built a more adequate war chest.
Even better would be to establish clear rules so that currency-swap lines with the Federal Reserve, which have been regularly deployed to save banks from dollar illiquidity, could be used to end excessive depreciations too.
To be sure, the U.K. is a large economy with deep capital markets and a widely owned currency, giving it much more room for maneuver than a nation like Turkey.
Fears of an unstoppable slide in the pound seem overblown.
But that doesn’t mean its sovereignty is unlimited.
What the Bank of England’s actions have again shown is that the limits the U.K. must observe have less to do with its own bond markets than with the price others are prepared to pay for its money.
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