By Geoffrey Smith
Investing.com -- Most political leaders get to have a honeymoon period. Not so Liz Truss – and she has only herself to blame.
The U.K.’s new Prime Minister and her finance chief Kwasi Kwarteng have managed to offend, anger or disappoint just about everyone in the country in a chaotic and reckless first month in office.
In doing so, they have also unleashed powerful forces in global markets that had been dormant for a decade. For the first time since the 2008-2009 financial crisis, there is a strong whiff of systemic risk in the air.
Thanks to her lavish promises of unfunded tax cuts and energy subsidies, the central bank has had to intervene to prevent the collapse of much of the U.K.’s pension system.
For a few hours last week, a destructive vicious circle formed in which pension funds had to sell their Gilts to meet margin calls on long-term interest rate swaps. The selling then pushed the funds’ hedges even further out of the market, requiring more margin and more liquidations.
The sight of hidden systemic leverage being exposed by a sharp adverse movement in interest rates was an uneasy reminder of 2007 and the first seizures in subprime credit markets that led, a year later, to the biggest financial crisis in 70 years. It was an instantly recognizable feeling, and inevitably prompted thoughts that similar weaknesses may be lurking in Eurozone and U.S. financial markets (to say nothing of Japanese and Chinese ones), waiting only for the right catalyst to trigger them.
The BoE’s operation is still ongoing – up to a final cost of 65 billion pounds. But even if it succeeds, the slapdash, tone-deaf way the government has gone about its business has all but destroyed its credibility with financial markets.
Truss inherited an economy with a small number of acute short-term problems (sky-high energy bills and raging inflation) and a large number of merely serious but chronic ones: the pandemic hangover, low productivity and growth, the lack of access to neighboring markets caused by Brexit, and the need to transition to net zero carbon emissions, to name but a few. The task at hand was to mitigate the most pressing emergencies while moving toward solving the longer-term ones.
Instead, Truss and Kwarteng magicked out of thin air over £100 billion of tax cuts and energy subsidies, in a thinly-veiled effort to juice the economy just enough for Truss to survive until the next election in 2024.
Nobody bought it: not the electorate, which was outraged by the skewed priorities of tax cuts for the top 2% of earners while much of the country struggles to choose between heating and eating; not the Conservative MPs who won their seats last time around on Boris Johnson’s radically different agenda of prioritizing deprived regions, and certainly not financial markets, which dumped the pound and pushed the government’s borrowing costs more than half a percentage point higher in a day.
Truss and Kwarteng have back-pedaled since then, reversing the announcement to cut the top rate of income tax, but the damage has been done. Indeed, they’ve added to it, sowing confusion over whether they will cut public spending to keep a lid on all their extra borrowing, and contradicting each other in public over whose idea the ill-fated top rate tax cut was. Remarkably, in an interview on Wednesday before her conference speech, Truss declined to answer a straightforward question about whether she still trusted Kwarteng to make the right decisions.
Benchmark 10-Year Gilt yields are now some 90 basis points higher than when Truss took office, a move that will require billions of pounds in extra debt servicing costs if it persists. The pound continues to languish, hurting importers and consumers alike. Short-term market rates have risen to reflect expectations that the Bank of England will have to raise interest rates higher and faster than it otherwise would have. That will ensure that whatever benefit voters and businesses had from their tax cuts will be swallowed up by higher mortgage costs and credit card bills.
In her defense, Truss hasn’t done everything wrong since arriving at 10 Downing Street. She is clearly not to going to drop Britain’s support for Ukraine and, in contrast to some of the noises she made as Foreign Secretary, she appears to be pursuing a more conciliatory course with the European Union, quietly dropping plans to introduce new legislation to rip up the U.K.’s Brexit deal. However, she has needlessly made life hard for herself – and may have let a market genie out of the bottle that many outside Britain will have cause to regret before too long.