Bond vigilantes sell bonds when they think government isn’t doing enough to control inflation. Dumping government bonds sends their prices lower and interest rates higher. Ed Yardeni, who coined the term in 1983, puts it this way, “if the fiscal and monetary authorities won’t regulate the economy, the bond investors will.”
In the last week of September Britain got a bitter reminder of what can happen when government blindsides the market. Only three weeks into his job, Liz Truss’s finance minister Kwasi Kwarteng unveiled a package of tax cuts and spending to cushion against energy prices and revive economic activity. His fiscal stimulus package was announced on Friday, September 23d, at the same time the central bank was tightening policy– raising rates and preparing to take money out of the economy, selling some of the bonds it had purchased during the Covid crisis. But importantly there was an absence of communication as Kwarteng didn’t prepare the markets for what was coming.
Big financial institutions—bond vigilantes—doubted Kwarteng’s plan would work. They sold UK treasuries, pushing interest rates higher and bond prices lower. The pound fell sharply against the dollar.
Then came an unanticipated consequence. Britain’s private pension funds– the biggest holders of government debt—had speculated on derivative instruments linked to bond prices holding above a certain minimum. When those levels were breeched, pension funds were forced to raise cash, doing so by selling bonds. What followed was a rapid downward spiral that was halted only on Tuesday, September 27th by the Bank of England reversing course, buying bonds and stabilizing the market.
By week’s end the pound recovered modestly from its record low of $1.03 to $1.08. Earlier in September the pound had been worth $1.14.
Recrimination and second-guessing quickly followed these “seven days that shook the UK.” Adam Posen, an American who had been a member of the BOE monetary committee, complained that Kwarteng’s package was reckless. Germany’s finance minister Christian Lindner lamented a lack of coordination– the government “stepping on the gas while the central bank steps on the brakes.” Vitor Constancio, former number two at the European Central Bank, said ever since Brexit in 2016 British authorities “had shown hubris as if they were going back to greatness and the days of empire.”
The practical effect of the market distress is that mortgage interest rates could now rise much more than anticipated. Imported energy will cost even more.
The September currency debacle is merely the latest in a string of devaluations going back decades. In 1949 the pound was devalued nearly 50% from $4.03 to $2.80. Regrettably, Britain continued to have big trade deficits and in 1967 the pound went down another 14% to $2.40. In 1992 a Conservative government sought to bring down a 6% inflation rate by linking the pound to the German mark. The experiment failed.
The pound matters because after New York London is the world’s largest financial center. Everyday $3.5 trillion of foreign exchange trading occurs in London. Financial services account for a disproportionately large share of British economic activity and employs over one million people.
If London is to remain a vibrant financial center it requires a stable currency, something that the latest pound crisis has called into question.