UK Bonds Issue?

[trajan]

On BBC News TV Channel this morning I happened on something that is absurd - at least to my ears.

The story goes thus:

UK budget promises tax cuts with no solid basis for funding public expenditure holes resulting from them. The bond market fears default in gilts so the price of these falls following selling by institutions holding a lot of them. This means that buyers of the sold gilts are getting a higher intetest return on these bonds. Now (here is my disconnect) this is said to be creating a problem for the UK government . . .

Where's the additional problem for the UK government due to this, since the cost of the bond coupon remains the same and the eventual repayment of say a £100 bond will be unchanged?

Is it because higher rates available in the gilts trade siphons away funds from competing financial markets and these are forced to up their rates in response to the new market conditions ?

Please excuse my macroeconomic innocence as I am but a humble rustic bumpkin engineer.

 

[joe sod]

I think it's more that the interest rates on new issue bonds for the British government rises therefore making it more expensive for them to finance everything since they are supposedly cutting taxes.
Because you can get higher interest rates on new issue bonds the price of existing bonds must fall to equalise interest rates. Just shows now how daft it was to invest in negative interest rate bonds during covid, I wouldn't like to be waiting around for a century to get my money back on those 100year Austrian government bonds at 1%. Now we have 10% inflation!!!

 

[trajan]

That is fine.
But the noise is about interest rates for borrowers, variable mortgage holders and so on.
So commercial banks therefore are following an interest rate increase begun in the public sector - as they must as their applied rate is constructed on the so-called base rate.

So, if this is all eminently predictable to those schooled in macroeconomics, why have they done what they've done ?

 

[MrViking]

We’ll be asking ourselves the same question after Sinn Fein get into power! Same reason.

 

[MrViking]

BTW, has anybody noticed how SF has dialled down the rhetoric around capping energy prices for consumers since the disastrous UK situation?

 

[jpd]

if the bond markets can frighten a country as big as the UK, frightening a country as small as Ireland will be chicken feed - get ready to welcome back the Troika

 

[cremeegg]

This means that buyers of the sold gilts are getting a higher intetest return on these bonds. Now (here is my disconnect) this is said to be creating a problem for the UK government . . .

Where's the additional problem for the UK government due to this, since the cost of the bond coupon remains the same and the eventual repayment of say a £100 bond will be unchanged?

So far no problem.

Is it because higher rates available in the gilts trade siphons away funds from competing financial markets and these are forced to up their rates in response to the new market conditions ?

Yes, although this is slightly further down the road and a problem for the UK economy as a whole rather than specifically a problem for the government.

A more direct problem for the UK government is that any new debt or old debt being refinanced will be at the new rates.

 

[cremeegg]

So, if this is all eminently predictable to those schooled in macroeconomics, why have they done what they've done ?

Truss and others in the UK government believe that growing the economy reduces the debt burden in relative terms. Arithmetically this is true, and apart from environmental concerns this has long been considered a sound policy objective.

They also believe that the best way to achieve growth is by reducing taxes, especially on the wealth generating sectors of the economy. This idea has a lot of support among economists generally, though it does rather depend on where the economy is starting from, are taxes too high to begin with ? will tax cuts drive inflation ? are there other constraints on growth ?

The market wants to see the overall plan. If taxes are cut where will the money to run the country come from. From increased tax revenue (due to the growing economy even though tax levels are lower). Through borrowing. Or through cuts to public spending.

Governments rarely make fiscal decisions without outlining their overall plan like this. Kwarteng said he would publish his plan in November, subsequently revised to end of Oct. In the UK they have the Office of Budget Responsibility which 'provide independent and authoritative analysis of the UK’s public finances'. Kwarteng didn't show them his plan either.

UK corporation tax rates are high, UK personal tax rates are not low. The UK govt approach may not have been the best approach to the issues in their economy but it was not unreasonable. The problem is that the markets think Truss and Kwarteng had no plan and were just making it up as they went along.

Because of all this, when the plan is eventually published in whatever form it has by then, it will receive a much more critical scrutiny, than it might have if they had just said day 1, We are cutting taxes, We are growing the economy, We are not concerned about inflation, We may borrow short term to finance public services, but growth will take care of that.

I think that there will be a further lurch downward for the UK when this plan is actually published. No matter what changes they make in the meantime.

 

[cremeegg]

if the bond markets can frighten a country as big as the UK, frightening a country as small as Ireland will be chicken feed - get ready to welcome back the Troika

If only we pooled our currency with part of a bigger block. That might have the strength to withstand bond market jitters.

 

[jpd]

Yes, using the euro will help, but EU will not bail us out without conditions - à la 2008, Greece, etc etc

 

[trajan]

@cremeegg Thanks for low-down. Though stated like that I wonder why Truss and Kwasi didn't just blurt it all out.
But Ireland's issues pertain more to a government impeding new housing than our treasury situation.
That is the primary inflation component over the last 6 years and in my view is the hidden hand in a lot of our recent "Ukrainian inflation".
Does the recent higher cost of diesel for Castletownbere trawlers cause the recent doubling in fresh fish prices ?
I think not. To me it's the fishermen - and everybody and anybody between us and them - availing of this excuse to award income increases to themselves - increases they can morally justify because of continually increasing house and rent prices.

 

[Jim2007]

if the bond markets can frighten a country as big as the UK, frightening a country as small as Ireland will be chicken feed - get ready to welcome back the Troika

Nonsense., it has nothing to do with the size of the economy. It has to do with confidence and ability to pay back. Ireland never had an insolvency problem, it has a liquidity problem as evidenced by its ability to pay down borrowing since 2007. The country has produce positive balances of trade for decades and that makes all the difference, because as Swiss bankers say - if you are selling more that you are buying you will eventually work your wait out ant financial difficulties. All through the last crisis we advised Swiss clients to continue and increase their investment in Irish bonds based on this simple analysis and they did very well out of it. And today the SNB holds a large block of Irish bonds as part of its reserve. The future is never the same as the past and you need to move on.

 

[cremeegg]

But Ireland's issues pertain more to a government impeding new housing than our treasury situation.

I agree that housing is Irelands biggest issue, from a social as well as an economic perspective.

It is a problem of success, the number of people at work in Ireland has increased considerable since the end of the pandemic. Infrastructure especially housing has not kept up.

I am not sure that government actually impedes new housing, but it has certainly failed to support housing enough.

 

[joe sod]

Nonsense., it has nothing to do with the size of the economy. It has to do with confidence and ability to pay back. Ireland never had an insolvency problem, it has a liquidity problem as evidenced by its ability to pay down borrowing since 2007.

But what about 2010, the markets didn't believe that Ireland had a liquidity problem but an insolvency problem that's why the interest rates on Irish government bonds rocketed then and Ireland had to go to the IMF to bail itself out as the bond markets effectively would not lend to Ireland . Yes the treasury management agency has managed the Irish government debt very effectively by managing to refinance a lot of it at very low interest rates before the latest big rises in interest rates. But we shouldn't get overly complacent or smug about the problems the UK is facing right now, we have a much higher per capita debt load than the UK and among the highest in Europe .
The buyers of the bond issues during covid in Irish debt are now down in money due to rising interest rates and falling bond prices. Also the Irish balance of payments surplus is highly dependant on a few US multinationals that are now facing their own issues with rising interest rates and profit warnings the latest from Intel and Novartis

 

[NoRegretsCoyote]

Please excuse my macroeconomic innocence as I am but a humble rustic bumpkin engineer.

The way to think about government bonds is that there are huge amounts of them outstanding, being traded all the time, but new issuance is very small. Ballpark 1% of total outstanding government debt is paid back and issued again every month. That's not very much.

So the immediate impact of rising rates on the outstanding debt is very little. The government still pays the coupon in line with the rate when the bond was issued, the government only pays more interest on new issuance.

However the impact of high rates can spread through the stock of debt over the course of a number of years. When you model this you model less money for government to spend which means more taxes, probably less growth, and less tax to service debt from. Debt dynamics are interesting - it depends on a lot of things but debt at 90% of GDP can mean that everyone will lend to you confident that they'll get their money back, whereas debt at 100% of GDP can mean that no one will lend to you confident that they will get their money back. Herding can be very strong - when everyone else is you will feel safe to do so, and when no one is investing you won't feel safe to do so. So some of this explains the big market swings visible over the last month.

FWIW I don't think the UK will in any meaningful way default. It issues all debt in its own currency so the worst that can happen to investors is inflation. They will still get their money back in sterling, it just might not have the purchasing power it once did.

 

[trajan]

FWIW I don't think the UK will in any meaningful way default. It issues all debt in its own currency so the worst that can happen to investors is inflation. They will still get their money back in sterling, it just might not have the purchasing power it once did.

Interesting.
But taking borrowers on their own currency is riskier and would be offset by a higher rate surely.
I see no risk of a default either - policies would be changed and elegant excuses made.
The Humphrey Applebys would see that's done at least

 

[joe sod]

However the impact of high rates can spread through the stock of debt over the course of a number of years. When you model this you model less money for government to specnd which means more taxes, probably less growth, and less tax to service debt from.

You forgot to mention cuts in government spending, we had to do that during the eighties and during the bailout, it wasn't a choice either remember,people won't pay large increases in taxation unless they see cuts in government spending as well, they vote with their feet and leave the country those that are young and skilled anyways.

1% a month on total government debt to be repaid every month is still 12% a year , so 3 years on the effect of high interest rates are going to be felt, because this era of high inflation and high interest rates still has a long way to run. There are shortages in the energy markets that will take many years and huge amounts of investment to address,Ireland hasn't built a new power station in a decade. The state could be hit with the bill for all this as well, because the private sector no longer wants to do it

 

[MrViking]

Final salary pension schemes have been a major purchaser of gilts for many years. It has worked well for the UK government, as an issuer of debt as there has been plenty of willing buyers (demand) to keep yields low. The major problem now is that UK final salary schemes are almost fully hedged and demand from this key historical buyer of UK debt has gone past peak and is in decline. Increasing gilt yields has accelerated this drop in demand. So the big question is, without these pension funds, who is going to purchase the extra supply of gilts…..in an environment where even more supply is likely coming on stream?? The situation here is going to get a lot worse, and yields will rise next week. Unless the chancellor can significantly reign in spending, expect a s*it-show by Christmas.

 

[joe sod]

But it's not just a UK problem it's universal, the acuteness is being felt in the UK now but everyone that has a pension is going to be hit by falling bond prices. Complacency crept in among pension providers that bond prices would rise to compensate for falling stock markets therefore they could safely invest in bonds . Now bond prices are falling along with stock markets so pensions are getting a double whammy, first time this has happened since 1970s.
Low risk pensions meant that pension providers just loaded up on bonds instead of stocks, that worked since the 80s but no more, now pensions are loaded with some of that horrible negative yielding bonds they bought during covid and before.

 

[trajan]

"Almost fully hedged" pension funds ?
Till now I'd thought hedge funds were only a way of laying off risks from conventional market trading - side-betting on periodic collapses in all shares, etc.
But it seems they are the wideboys of the financial markets: short-selling, arbitrage, etc.
Boys, oh boys.
The UK bond market brought to crisis through aggressive trading by fund managers for the nation's pensioners'.
And for themselves, of course.