The not-so-mini budget that nearly caused another Lehman moment
The economic landscape of the United Kingdom witnessed significant turbulence under the leadership of Prime Minister Liz Truss. Liz Truss assumed office on September 6, 2022, and in line with expectations, she articulated a pessimistic perspective on the prevailing economic conditions and proposed a course of action (How a “Mini-budget” Almost Caused a UK Lehman Moment, 2022). At the time of her appointment in 2022, the UK economy was experiencing an economic slowdown due to the aftermath of BREXIT, COVID-19 restrictions, unprecedented inflation rates, and surging energy costs triggered by Russia's invasion of Ukraine. Liz Truss confronted this myriad of economic challenges by introducing what came to be known as the »mini-budget«, which would encourage economic growth (How a “Mini-budget” Almost Caused a UK Lehman Moment, 2022). This fiscal initiative was announced by the Chancellor of the Exchequer's, finance minister Kwasi Kwarteng, in the fiscal statement "The Growth Plan 2022" (Quinn, 2022). Hailed by her supporters as “at last, a true, Tory budget”, the mini-budget did not turn out so mini. Ironically, the mini-budget included unprecedented tax cuts amounting to £45 billion of unfunded tax cuts, the highest since 1972, alongside the imposition of energy price caps. Altogether, the mini-budget featured £76 billion of unfunded government borrowing over the next six months alone, all the while making a rather vague attempt to assert that an improbable economic boom could foot the bill. Without a clear alternative income source for the government, aside from miraculously covering its own costs, this fiscal approach was heavily criticised not only by economists but by entities such as Goldman Sachs, Bank of America, and the IMF, agreeing that this big gamble came at the wrong moment for the economy. Furthermore, The City UK cautioned that extensive tax cuts might have a counterproductive effect, potentially hindering economic growth rather than fostering it (How a “Mini-budget” Almost Caused a UK Lehman Moment, 2022).
This article will analyse the consequences of the 2022 mini budget, specifically on the treasury bond market. It will first lay the circumstances of the treasury bond market before the mini budget announcement and then analyse the consequences of the mini budget on the bond market. Furthermore, it will analyse some other relevant fields that were affected by the mini budget. The article will end with explaining the role of the Bank of England and a connection to the theory of Keysian economics, in which it will argue that this incentive would not even work in theory.
The UK bond market was already facing challenges even before introducing the mini-budget. The aforementioned high inflation affected the gilt market (bond market) negatively because it eroded the purchasing power of money. When investors hold gilts with fixed interest rates, the real returns, adjusted to inflation, may decrease. With decreasing real returns, investors were not inclined to hold onto the gilts, especially since the US Federal Reserve (Fed) tightened its monetary policy, resulting in higher interest rates and attracting investors to move their investments from the UK to the US (Kenda, 2022). Thus, as the UK's tightening inflation implied lower expected real values of future bond payments and the US bonds became more attractive, investors moved their investments, and the demand for UK assets lowered (Kenda, 2022).
Consequently, as the demand for UK bonds lowered, their prices dropped, and their yields (interest rates) increased. The Fisher effect explains this in the following manner: because of high expected inflation, investors demanded higher nominal yields on UK bonds to compensate for the decrease in the real value (How a “Mini-budget” Almost Caused a UK Lehman Moment, 2022). Fisher's equation is that the real interest rate equals the nominal interest rate minus the inflation rate. With an increasing inflation rate, the only way to maintain a positive (or high) real interest rate is to increase the nominal interest rate. As yields (nominal interest rates) were expected or even demanded to increase, the gilt prices decreased due to the inverse relationship between bond prices and yields (Kenda, 2022). This relationship stems from the idea that when market interest rates rise, new bonds are issued at these higher rates and are, therefore, more popular than the old bonds. In order to make investors buy older bonds, the prices have to be lower to make the bond yields competitive with new bonds, otherwise, investors have no incentive to buy bonds with a lower interest rate (Understanding Bond Yield and Return | FINRA.org, 2022).
After the announcement of the mini-budget, investors feared two things, which caused them to sell their UK bonds. Firstly, investors feared permanent inflationary pressures since the tax cuts increased the public's disposable income, which is supposed to increase aggregate demand for goods and services, increase economic spending, and, in turn, put pressure on prices (How a “Mini-budget” Almost Caused a UK Lehman Moment, 2022). Those increases would supposedly lead to an economic boost. However, if the increase in aggregate demand surpasses the supply, it can lead to a demand pull inflation. Investors were justified to be worried because the UK was already facing high inflation. As inflation increases even more, monetary policy would be expected to increase interest rates in order to make borrowing more expensive and minimise the effects of inflation. Rapidly increasing interest rates paired with an already weak economic environment is a potential recipe for recession (Kenda, 2022).
Secondly, the investors were skeptical whether the potential economic stimulus of the tax cuts would be sufficient to justify the increase in the national deficit (How a “Mini-budget” Almost Caused a UK Lehman Moment, 2022). On one hand, tax cuts and increased government spending can stimulate economic growth by increasing disposable income and demand. On the other hand, however, these measures would also significantly increase the government's borrowing needs, as they were not accompanied by corresponding increases in revenue (How a “Mini-budget” Almost Caused a UK Lehman Moment, 2022). A national deficit implies that the government would need to borrow more money, which raised concerns for the country's long-term fiscal health, especially because of the increasing interest rates, as explained in the previous paragraph. The trade-off between a short-term boost and a long-term health, between stimulating economic growth and maintaining fiscal stability, was what investors were questioning.
It all boils down to inconsistencies between the monetary and fiscal policy, the latter being extremely loose and the first tightening up. Such inconsistent behaviour leads to lower trust in the system.
As a result, investors sold their UK bonds, and the gilt market experienced its biggest daily loss since the early 1990s on September 26 2022 (How a “Mini-budget” Almost Caused a UK Lehman Moment, 2022). As investors questioned whether or not to hold onto UK bonds, they were assessing the risk of holding these bonds with the upcoming situation. The sell-off was driven by a desire to reduce the exposure to a perceived higher-risk investment. With most investors selling their bonds, the supply of bonds in the market increased, which led to a drop in their prices. This is in line with the basic supply and demand dynamics – as the supply of an item increases, its price usually falls if demand cannot keep up. With a lowered demand for UK bonds and excessive supply, their prices decreased (Lakeland, 2023). Since bond prices and yields have an inverse relationship, as was already explained, the bond yields drastically increased. As always, the rise in the yields represented a perceived risk increase with holding those bonds, and the higher yields were compensation for holding what was considered a riskier investment. Consequently, higher yields meant that the new government borrowing would be even more expensive, as new bonds would have to be issued at these higher yields to attract buyers. The highest bond yields since the early 1990s signaled that investors are concerned about the country's fiscal and economic outlook.
The chart below begins with the announcement of the mini-budget, which leads to an immediate rise in the yield of the 30-year gilt. The yield was set around 3.8% when the mini-budget was introduced and then increased to almost 5.1% before the Bank of England intervened. This significant jump from nearly 4% to 5% suggests that market prices of the bonds fell sharply. On the 20th, an investor would earn an annual return of around 3.8% on his investment, but on the 29th, he would receive around 5% (How a “Mini-budget” Almost Caused a UK Lehman Moment, 2022).
The British pound experienced a sharp decline in value against other major currencies, specifically the US dollar, in the immediate aftermath of the mini-budget announcement (Kenda, 2022). As the mini-budget raised concerns about the UK's fiscal health, the (international) investors decided to sell off their UK bonds and convert the pound to another currency, such as the USD, increasing the supply of GBP on the currency market. After the currency conversion, the investor moves his funds out of the UK to a safer and more profitable investment (Kenda, 2022). The aggregate effect of such behaviour causes a capital outflow from the UK, causing the pound to depreciate (decline in value). When capital outflows are very large, like in the case of the 2022 UK, they can lead to currency depreciation, reduced investment, and potential economic instability (Kenda, 2022). The Central Bank's and the government's job is to regulate these instances.
Another victim of the mini-budget were the pension funds. Pension funds work by using the so-called liability-driven investment strategies (LDI). These are ways for pension funds to manage their investments by focusing on their future payment obligations – liabilities . The pension fund has to invest money to have a sufficient amount in the future, adjusted for inflation. Therefore, it tries to match its investments with its liabilities by picking investments that are expected to grow and are not as risky. It invests in bonds because they pay a steady amount and are usually more predictable than stocks. Pension funds can also borrow money to make these investments, which can be risky if the investments do not work out as planned (Team, 2023).
The pension funds use so-called derivatives, like financial bets, that get their value from the interest rate on bonds (in this case) (How a “Mini-budget” Almost Caused a UK Lehman Moment, 2022). Pension funds made a financial bet that the bond prices would stay stable or predictable, knowing that that is how it has been for the past decade. The sudden increase in the interest rates was followed by increases in margin requirements, which had to be met within hours, leaving little time to provide the so-called collateral. Since the remaining cash was invested in riskier assets, pension funds faced a liquidity constraint problem. To meet the margin calls, they had to liquidate their assets, and the only option was to sell government bonds. Their selling further exacerbated the fall in bond prices and rise in yields. This is a gross simplification of the actual situation, however, it presents the basic dynamic between bond prices and pension funds. If the Bank of England had not intervened, there was a risk that some pension funds could have faced insolvency, as they might not have been able to meet the margin calls, which could have led to a broader financial crisis (How a “Mini-budget” Almost Caused a UK Lehman Moment, 2022).
With this horrifying situation, the Bank of England had to step in, which it did on September 28 by announcing it would purchase long-dated gilts on »whatever scale is necessary« till October 14 (How a “Mini-budget” Almost Caused a UK Lehman Moment, 2022). By doing so, it increased demand in order to stabilise prices and lower yields. By setting a due date, they made it clear that this was a desperate temporary measure to stop the panic and give the market some breathing space (How a “Mini-budget” Almost Caused a UK Lehman Moment, 2022). However, some found this move counterintuitive with the BoE's goal to bring down inflation since buying £5bn worth of gilts daily for 13 days increases the BoE's balance sheet and injects more money into the economy, which will likely cause inflation in the long run. The BoE's defense was that "were dysfunctions in the [gilt] market to continue or worsen, there would be a material risk to the UK's financial stability" (How a “Mini-budget” Almost Caused a UK Lehman Moment, 2022). The BoE tried to prevent a pension fund liquidity crisis, which was underway, and break the vicious cycle. It was not a typical monetary policy move but a response to an immediate crisis.
The decision to substantially cut taxes cannot be explained within course-related theories. Its effects, however, can be simplified to fit within Keynesian economics. Tax cuts influence aggregate expenditure by increasing disposable income. Thus, individuals have more after-tax income, which increases consumption spending. The increase in consumption contributes to a higher aggregate demand, an upwards shift in the AD curve, which leads to an increase in output (Y) or to an overall increase in economic activity. Another aspect is the tax multiplier, which suggests that an initial decrease in taxes leads to a multiplied increase in national output (Y). This can justify why the government implemented such substantial tax cuts, believing they would lead to a multiplied increase in Y. However, the Keynesian perspective also includes that while fiscal stimulus is effective in times of economic slowdown, doing so in an already high inflation environment could only worsen inflationary pressures. Furthermore, unfunded tax cuts raise concerns about increasing public debt, which can undermine long-term economic stability, if there is no plan at hand. Had Liz Truss only opened a simple textbook from macroeconomics, the UK economy would have been spared a drastic setback.
In conclusion, Liz Truss's "mini-budget" was intended to tackle the UK's economic challenges but, ironically, led to a sell-off in Treasury Bonds. The absence of corresponding revenue measures and the unprecedented level of unfunded borrowing triggered a loss of confidence among investors, sparking a chain reaction in the financial markets. The Bank of England's intervention was a crucial step to prevent a further escalation of the crisis, highlighting the delicate balance between fiscal policies and market reactions in maintaining financial stability.
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