Investors slipped into gilts | The Manila Times
The events of the past few weeks in the UK financial market, which the Bank of England is now trying to save, are a handbook of what can be done wrong, but also a warning.
The experience with the new British Prime Minister Liz Truss and her equally new Chancellor of the Exchequer Kwasi Kwarteng has been extraordinary.
To revive the British economy, the new British government has passed a new tax reform, the main element of which is tax relief for individuals. But within 48 hours, the tax reform instead led to a spontaneous crisis in UK financial markets. It’s so bad that Britain’s central bank, the Bank of England, continues to stabilize the government bond market; gilts is the official name.
The hard lesson
My first thought on the very strong market move was that if there is so much stress in the UK financial system, is there a big overlooked danger lurking just below the surface?
One thing is certain: the communication on the tax reform from the political side was hopeless. Not because I think the financial sector should receive particularly sensitive communicative treatment, but because the total financial market is made up of many people, including ordinary people who save or invest privately.
I can only cite the US central bank, the Federal Reserve, as a good source of inspiration for this lesson. This organization is a class apart when it comes to guiding investors and financial markets on what to expect from central bank actions.
This lesson has proven costly for many UK homeowners who have seen interest rates soar. The increase in interest rates could have happened anyway, but not so quickly. At the time of this writing, a UK homeowner would pay around 6.50% for a two-year fixed interest rate.
Going back to the stress symptoms, this was a surprisingly strong reaction in the gilt market. The government would carry out its tax reform unfunded, creating such mistrust in British public finances that it immediately led to a massive sale of government bonds. This hit several UK pension funds so hard that they had to force-sell gilts, and the gilts market effectively collapsed. The Bank of England had to enter the market and, in principle, buy the gilts that the market cannot absorb on its own. That pension funds are affected in this way is remarkable, and it requires further examination.
For homeowners, this has unfortunate consequences in addition to the rise in interest rates itself. Mortgage banks calculate their lending rates based on the yield curve linked to the gilt market, but once that is gone, yield curves don’t exist either. As a result, interest rates on home loans cannot be fixed and homeowners can only watch interest rates rise without being able to lock in the interest rate.
A wake-up call for Europe
I see that all this mess is some stress in the UK financial system and economy. But I also take it as a warning that a growing part of Europe will experience public debt and housing market stress crises.
Years ago, my assessment was that the next crisis in Europe would be precisely the fear of a mountain of public debt that cannot be repaid. This leads to the ultimate distrust of the financial market, and the solutions will be unpleasant medicine. However, I believed that this situation would develop by the end of this decade. But, as so often before, financial markets are moving much faster than expected.
In the short term, the UK government will have to work overtime on plans for the UK economy. It must be more convincing, but we must also work to restore confidence in the financial market. In addition, the mortgage banks must also meet because at the moment, access to credit for real estate financing continues to be reduced. Even in the past few days, some mortgage banks have closed their doors to home loans with loan-to-value ratios above 75-80%.
This immediately creates a further drop in activity in the English property market. In my opinion, the negative spiral is still descending, and it’s a good question to ask how long it will last.
I would be very surprised if the Bank of England did not stabilize the market to the point where it was back to normal. Thus, the market for interest rate swaps becomes available again so that mortgage banks can price their real estate financing. It’s a long chain that needs to get back in order, but even if it’s so far away, I don’t expect the spiral to necessarily stop, although it does at least spin slower.
It’s not a rosy story, and it’s a sudden wrong turn in the UK. But central banks have pushed the party with low interest rates far too far and for too long, so now the hangover comes with falling house prices in Europe. The current experience of the UK property market is just one of many to come in Europe.
Peter Lundgreen is the founding CEO of Lundgreen’s Capital. He is a professional investment advisor with over 30 years of experience and a leading entrepreneur in the field of investment and finance. Lundgreen is an international columnist and speaker on topics relating to global financial markets.