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ZorbaTHut  2yr ago (text post)   35663 thread views

Culture War Roundup for the week of September 26, 2022

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Also , the collapse of Euro, Yen, AUD, and Pound, and the surge of US dollar. Even when things seem to be going badly here, things are worse overseas, like higher inflation, worse energy shortages , more unrest (like in Iran now).

Funnily enough I was thinking how once again Australia was passing through with a much more mild economic cold than the rest of the West (inflation has consistently been a few points lower than the US). A falling currency is also not necessarily a bad thing for a net exporter.

A falling currency is also hardly a bad thing for a net exporter.

There's a good rule in economics: never reason from a price change. Always ask why the price is changing. An exchange rate is the price of a currency in terms of another currency.

It depends why the currency is falling. If the purchasing powers of trade partners are increasing, that's probably a good thing - more spending by people buying your products. If your currency is overvalued, that's also a good thing - exports become more profitable. If you are overstimulating your economy or your exports are falling, that's a bad thing, although it's still best for many economies to let the exchange rate (rather than the whole domestic economy) handle the adjustment to the problem, and so the change in the currency value is unpleasant but necessary.

I was hoping one of the resident fin* people here with connections to London would have a top level on what's going on with the pound in particular. Seen some analysis that the new governments financial policies were a mismatch for ground level economic realities especially combined with energy subsidies for the coming winter. Then a much further downstream technical analysis of how a volatile bond market might have almost nuked pension funds.

At a very high level, the sterling/gilt crash is mostly driven by what finance Twitter is now calling MRP (short for Moron Risk Premium). The UK Deep State has a reputation for basic competence (Dominic Cummings thinks this is undeserved, but most investors disagree with him), whereas the clique of right-wing Brexit-supporting Tories that put Truss into power has a reputation for badly botching the technical aspects of Brexit. So when the Truss ministry publicly blows off the Deep State while simultaneously embarking on a questionable economic policy, investors worry that the British government is no longer going to display basic competence. It doesn't help that bankers can see the UK regulators visibly struggling to cope with onshoring financial regulation post-Brexit, which also creates a stench of Brexity incompetence. (This isn't actually a competence issue, it is a workload issue. The UK needs more bureaucrats as a fully sovereign state than it did as an EU member, but it is politically unacceptable to hire them).

When the government doubles down by saying the crisis is everywhere and not just the UK, blaming the remoaner IMF, attacking bond markets as woke etc. this obviously makes things worse.

At a semi-technical level, https://ukandeu.ac.uk/whos-afraid-of-fiscal-dominance/ is a good essay explaining to laymen what the scenario is that investors dumping the pound are worrying about.

I will do a separate post on the gilt market problem.

The weird pension fund insurance stuff was one of those classic things that nobody thinks will go wrong until it does (as I understand it, and I don’t, it was effectively a kind of leveraged insurance product designed not to improve returns but to stabilize them over decades, because obviously pension funds have to disburse funds when times are bad as well as good). Pension funds got margin called, and therefore had to suddenly sell long-dated gilts which crashed the market because there were fewer buyers than every pension fund unloading them simultaneously, so the BoE was forced to step in to stabilize the market. I don’t think it realistically counts as a full resumption of QE but obviously it is a hilarious setback.

The short version of what happened to the pension funds is:

  • Pension funds have future-dated liabilities. Falling interest rates raise the NPV of these liabilities, potentially causing the pension fund to become accounting-insolvent.

  • UK regulation makes it a bad idea to allow a pension fund to be accounting-insolvent, so pension funds want to manage this risk. The main way they do this is using long-dated interest rate swaps. Effectively this is a side bet on interest rates - if interest rates fall, you win enough on the swap to cover the increased liability.

  • Market interest rates rose, fast. This meant that pension funds lost money on the swaps, and faced margin calls which needed to be paid in cash in the very short term (days, not weeks). But the offsetting gain from a falling NPV of liabilities is a purely paper gain. So pension funds were in danger of becoming cash-insolvent.

  • In addition, rising interest rates reduce the value of long-dated government bonds, which are a popular form of collateral. The 50-year gilt was briefly trading at 40p in the £ (not because anyone was afraid of a default, just because the interest rate suddenly became below-market). If you were using this gilt as collateral, you would be facing a margin call even if you hadn't lost money.

Whatever you call it, the BoE was forced to print money to cover government (planned) deficits that the bond market couldn't bear. This is bad.

Oh, it's getting real bad here. The £2 billion 45%->40% tax cut that the proles have gotten into a tizzy over really isn't causing much of the issue, it's more the huge additional borrowing for nat gas without enforcing a windfall tax plus the fact that the BoE is gonna start selling their QE gilts back into the market at a lower rate than it bought them at very soon (the costs are indemnified by the Exchequer, it's gonna add another £150bn plus to their outgoings, more than 2x the gas subsidies too).

The UK has fucked up big time, and you can't even say it's all the fault of Truss+Kwarteng, those gilts purchased during the pandemic were going to have to be sold at some point given how bad inflation was getting.

The big problem with the 45% tax cut is that it makes it politically impossible to cut spending (certainly, investors think it does, which is what is moving markets). If Kwarteng had announced only the corporate and middle class tax cuts while promising to find offsetting spending cuts in the next couple of months, he might have been believed.

Didn't they also ditch their fiscal rules? I remember people 10 years ago in the UK saying that austerity was a waste of time. Turns out it wasn't: markets really do care about the management of an economy and they don't like massive debasement of its value.

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