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Rather surprisingly, a UK tabloid newspaper recently contacted the author following the seemingly spectacular “blow up” in the UK bond markets, and the subsequent “crises” within the pension / insurance sectors. The journalist clearly wanted to write a story about reckless spendthrift government fiscal policies, and miss-management by pension fund managers. However, this was not the story that they got from the interview.

Yes, the Truss administration had been more than a little unwise to provide a net fiscal stimulus to what was an already overheated economy that was clearly suffering the effects of the Post Pandemic inflation. Moreover, running a larger budget deficit in the face of an already difficult funding environment was also probably not a good idea. Finally, it is also true that pension and insurance managers had indeed moved out along the risk curve into assets structures that they probably should not have purchased or entered into. All of these were of course true but, to our minds at least, these were the “effects” of a more fundamental problem, and certainly not the not the underlying causes.

The big problem in the UK bond markets in October this year was quite simply that yields were too low as a result of the Bank of England’s and the Finance Ministry’s sustained infatuation with, and devotion to, Quantitative Easing and other versions of central bank asset purchase schemes.

For example, those asset managers that needed a yield from their bond holdings had been forced into inappropriate and often leveraged structures by the low base level of yields in Gilts that had been caused by the BoE’s actions. Had Gilt yields been higher, then there would most likely have been more potential buyers for bonds when new supply was released. Higher yields might also have prevented the economy from overheating - and hence would have controlled inflation earlier.

The real “villains” of the story were therefore not those that had reacted to the low yields, but the finance officials and central bankers that created them. Policymakers seemed in 2020 to have adopted the view that, since some “QE” and the accompanying low level of yields was perceived to be “good”, even more “QE” must be better. It was these consensus / group think officials that drove yields so low that they implied that, particularly from the savers’ perspective, the bond markets were simply no longer fit for purpose. We suspect that many people reading these pages already knew this to be so…

UK: 10 Year Gilt Yield

adjusted for CPI Inflation, % pa

There are certainly historical episodes in which QE was extremely successful and indeed beneficial in supporting growth, particularly when the proceeds were used to finance the creation of productive resources, usually just before the funds were removed again via some form of “QT”. We would even argue that the Fed’s QE1 in 2009 was on the whole beneficial to the system, given the role that it played in providing the required funding for what was a much-needed fiscal stimulus at that time.

However, when central bankers around the world fired off their Pandemic-era QEs, they did so in a state of panic; often without proper analysis (and in some cases without even the ability to do such analysis); and under immense political pressure to be seen to do “lots”.

We recently asked a former senior central banker just how much he thought the central banks had understood about not only the size of the shock to aggregate demand implied by the lockdowns etc, but also the impact that the Pandemic was having on the economies’ ability to produce output. He admitted that they had possessed only scant information on the former, and little or nothing relating to how constrained or compromised the supply side of the economy had become during 2020. They were in effect firing off stimulus entirely “blind” with little or no ability to calibrate what they were doing, but with a distinct bias towards erring on the side of doing too much.

In such a world it was hardly surprising that they provided too much stimulus, that they pushed yields down much too far, and that they succeeded in triggering inflation.

In the UK, we suspect that the economy’s ability to supply goods and services has declined by at least 2-3% since 2019 but the stimulus to demand has led to people’s desire for output rising by several percentage points. This has created intense shortages of builders, waiters, airline seats etc etc and the result has of course been higher inflation. This story has of course been repeated – albeit usually to a lesser extent – in many countries around the World.

The solution to this inflation problem is either more supply (always hard to do) or less demand, and reducing demand is usually known as a recession. We are therefore convinced that the world, if it is not already in a recession, it will be in one soon as governments ostensibly seek to confront inflation by reducing aggregate demand.

What we are worried about, however, is that the consensus of policymakers and certainly most financial market participants want to see economic conditions remain so weak that they justify the former (unjustifiably) low levels of bond yields.

Just last week, the UK finance minister announced that he wanted to see bond yields back down to their previous levels in order to “reassure markets” and, in an effort to achieve this, he has embarked on an aggressive tightening of fiscal policy. The economy certainly needs a degree of recession in order to control inflation, but we would question whether it really needs such a deep recession and such a draconian response from policymakers simply so that unjustifiably low bond yields can be regained (by creating a severe degree of economic weakness).

The UK – despite our journalist friend’s desire to prove otherwise – is not an isolated case. We are told that the Biden Administration itself fears experiencing a “Truss Moment” in the Treasury Market, and one is certainly very possible over the coming days. The Brazilian central bank has evoked Truss’s name when calling for fiscal conservativism in that country in order to prevent yields from rising; while the fiscal maths in the Euro Zone also looks anything but assured. Japan’s Ministry of Finance has long demanded that the Bank of Japan keep yields low so that its immense fiscal debt remains relatively cheap to rollover and finance.

We have reached a point at which the world’s numerous overly indebted governments need and desire yields to stay low in order that they can remain “solvent”. Savers, however, need higher yields; while many savings institutions also need higher yields over the long term but cannot afford the capital losses that would be associated such a move (as the UK has proved). All of which takes us back to our first point; namely that years of consensus policymaking and QE have brought us to the point at which the bond markets are broken.

Over the medium term, we would not however choose this moment to fight the consensus. While we expect occasional “flash crashes” in bond markets in the immediate near term, as rising issuance causes periods of market indigestion, next year the fast-approaching global recession will most likely allow bond yields to fall back and give the public sector what it wants. However, we very much doubt that Western economies will want to accept perpetual Japan-like recessions.

At some point, and most likely by 2024, we can assume that governments will be obliged into providing a stimulus, into allowing the economies to recover and at this point the tension on the bond markets that we have witnessed over recent weeks will likely resurface.

Indeed, we fear that as governments change and populations require the resumption of growth after what will have been a difficult 3 – 4 years, the fiscal authorities will finally have to suffer the costs of rising yields in 2024. At this point, it will probably pay to be well clear of the debt markets as they seek to return to something resembling a more rational – but higher - yield structure. In 2024, policymakers will have to choose between presiding over perpetual recessions so as to justify ever-lasting low borrowing costs, or allowing their borrowing costs to rise as economic activity – and we fear inflation – returns. Japan with its weak demographics of course took the generation-long recession route in the 2000 and 2010s, but we doubt that the US and UK would accept such a bleak outcome. If this is the case, then bonds will not be a safe asset during the middle of this decade.

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