Vladimir Lenin, the revolutionary founder of the USSR, once said:
“There are decades where nothing happens; and there are weeks where decades happen.”
To which pension fund managers might nod in agreement after the week they’ve had.
Because after being bludgeoned into dormancy for a decade, the UK government bond (gilt) market has sprung to attention like Frankenstein’s Monster shocked into life.
And just as with that confused and lumbering creature, it quickly began to break things.
Indeed pension funds became so battered by the rate gilt prices were falling that their plight prompted a massive intervention by the Bank of England.
Lenin faced armed resistance to the Marxist makeover of his October Revolution.
But it seems chancellor Kwasi Kwarteng has to deal with bond vigilantes.
Armed and dangerous
The vigilantes label fell into disuse in the low interest rate era we’ve just lived through.
But the idea speaks to deep-pocketed traders who ‘police’ the markets – by dumping bonds in response to what they deem fiscally unsound government policies.
Such traders are naturally just out to make a profit – or avoid a loss – like any of us in the markets.
Yet because the appeal of gilts is so closely tied to the economic outcomes of government policy – and because the government also drives gilt supply through its borrowing – it’s easy to paint bond traders as bloodthirsty accountants seeking vengeance if the sums don’t add up.
Of course, any vigilantes need ammunition to fight their battles.
When interest rates were next to nothing and central banks were soaking up bonds with quantitative easing, the traders didn’t have much firepower.
But high and persistent inflation has done for all that.
The Bank of England – and its global peers – have instead been raising interest rates.
Our Bank even announced it would start selling gilts, too, to start unwinding quantitative easing.
Hence gilt prices are moving again… and the moves really matter.
Battle zone
The volatility so far in 2021 was notable, but it pales compared to that following the Mini Budget.
Bond prices immediately plummeted. Yields soared.
To give just one example, the iShares UK Core Gilt ETF fell 10% in four days.
That’s a crash in an asset class most hold for its stability.
Lenders withdrew hundreds of mortgages, fearing they couldn’t be priced with yields shifting so quickly.
The already-weak pound fell further after the International Monetary Fund warned our new government’s plans risked higher inflation.
Then the drama really escalated as pension funds were roiled.
Gilts fell so quickly that fund managers were struggling to maintain hedging strategies designed ultimately to ensure they could meet the income promises made to pensioners.
Which seems to have been the last straw for the Bank of England.
Far from selling its gilts, the Bank pledged to spend another £65bn buying more gilts to keep the market orderly. And presumably to give pension funds enough time to avoid blowing up.
Escalating tensions
Perhaps by the time you read this things will have settled down.
Or maybe not.
Either way, it’d be a mistake to dismiss these ructions as some esoteric contest played out by testosterone-fuelled City traders.
Because politics aside, what we’re seeing is a financial system grown complacent on low rates suddenly getting whacked with resurgent borrowing costs.
It’s been made especially chaotic because it happened so fast.
But the direction of travel for yields – up – has been clear all year.
And higher yields matter for our personal finances and for the companies we invest in. It indicates borrowing is becoming more expensive across the board.
The Bank of England says its new support is temporary – and I’d bet prices will start to fall again when it raises interest rates, though hopefully in a more measured fashion.
Either way, markets will get to grips with volatility being back eventually. Pension funds – and others – will adjust. Institutions will be better prepared for more wild moves.
And the Bank of England will continue to raise interest rates.
Yet there will still be more consequences as higher rates roll out across the real economy.
First strike
As stock market investors, we got an early dose of the regime change.
Rising interest rate expectations fed into analysts’ valuation models and reduced the attractiveness of company cashflows – especially far distant earnings.
As a result the most highly-rated growth stocks saw their share prices down even back in 2021.
Investors turned to so-called value stocks. These seemed a better bet with rising inflation and rates.
And indeed lowly-rated value shares have done better than their growth cousins recently. A big weighting to ‘old economy’ value shares is one reason the UK market has held up better than most markets in 2022. (The other is the weak pound, which boosts earnings).
As interest rates have continued to climb, however, investors have started asking whether central banks will push economies into recession.
Recessions aren’t good for value stocks. So now their shares are sliding as such fears grow, too.
And here finally we get to the impact of higher rates in the real economy.
On the home front
Inflation aside, this drama that’s taxed economists, policymakers, and investors in 2022 hasn’t impacted most people’s everyday life very much.
But as higher market yields lead to pricier loans on the High Street, that’s changing.
Spiking yields mean more costly mortgages, even for longer-term fixes. Will straightened consumers cope? Or will the housing market creak or even crash?
Then there are the borrowing costs for companies.
For years we’ve heard about ‘zombie’ firms kept alive with cheap credit. With rates going up so quickly, we might witness a real-life zombie apocalypse!
There will be winners, too, such as savers with cash in the bank, although their higher interest income won’t be very exciting in real terms until inflation subsides.
Still, higher returns on safe cash deposits presents yet another headwind for shares.
Instead of bond vigilantes, in the low-rate era we had TINA – There Is No Alternative.
The acronym steered investors wanting a positive return away from low-yield cash and bonds and into equities.
Today though, there is competition. A 10-year gilt now yields 4% for example. That’s worthwhile.
Not enough to beat double-digit inflation, it’s true. But the Bank of England still expects inflation back towards its 2% target relatively soon.
Besides, most of us would gladly take 4% compared to negative returns in our portfolios this year!
Winning the peace
It all sounds grim. But most of us knew – even hoped – cheap money wouldn’t last forever.
Besides there’s not much we can do about it.
We can ensure our portfolios are diversified and invested the best way we know how. We can keep a lid on debt, and even step up our savings rate to help make up for recent losses.
Beyond that, it’s a matter of waiting it out.
Don’t be too alarmed, especially if you’re a new investor. Frightening episodes come along more often than you’d think. Yet those who invested wisely have made life-changing gains regardless, given enough time.
That pundits dusted down the ‘Black Wednesday’ moniker from the 1990s to repurpose for the post-Budget tumult reminds us we’ve similar before – and yet investors triumphed eventually.
I mean, that’s why we still have a 300-year old London stock exchange.
And Lenin has now only statues.
