Did the Bank of England do for Truss, rather than the financial markets?

It’s now common currency that Liz Truss was forced to resign as Prime Minister because the international financial markets were so spooked by her disastrous mini-budget that Britain was about to be brought to its knees. 

It’s a story that is being repeated just about everywhere you look or read, in most of the national press, on TV, to such an extent that her own party’s critics – as well as Labour – can continue repeating the mantra that Truss crashed the economy. 

One Bloomberg article went so far as to claim this week that hedge funds now have their first Prime Minister in Rishi Sunak, such is their power. The suggestion that these all powerful mysterious funds are so omnipotent and that by taking positions in the markets they forced the Tory party’s men in grey suits to whisk Truss off into the night. 

Here’s a different analysis from across the Atlantic, and a fascinating and far more realistic view which better explains the background to what happened over the last few tumultuous weeks. 

According to an eminent American economist,  it is the Bank of England which is to blame for pulling the plug on Truss rather than the markets punishing her for her alleged fiscal profligacy.

In a powerful article for Bloomberg on Wednesday, Narayana Kocherlakota, a professor at the University of Rochester and a former president of the Federal Reserve of Minneapolis, had this to say: “I see a very different story. Markets didn’t oust Truss, the Bank of England did — through poor financial regulation and highly subjective crisis management.”

If you think that the professor is partisan and in favour of Truss’s policies, think again. The reverse is true. Indeed, he agrees with most observers that her promises of tax cuts and spending increases might lead to higher inflation, higher interest rates and quite possibly higher unemployment: ” But such adverse outcomes take months and years to play out. Her government fell in a matter of weeks. How could this happen?

It’s an important question. As Kocherlakota reminds us, over the three days from Friday, September 23, the day Kwarteng announced the budget, the pound fell by 2.2% against the euro and the FTSE 100 index dropped by 2.2%. As he says: “Notable movements, but hardly enough to bring a government to its knees.”

Quite. These are hardly earth-shattering moves. Sterling, for example, has been falling against a stronger dollar all year ever since the Federal Reserve started tightening monetary policy with higher interest rates. The pace stepped up after Jay Powell, the Fed’s chairman, declared at the Jackson Hole symposium in late August that the US would take a bludgeon to inflation. Higher rates everywhere in the world were on the cards.

Cue the pound, along with the euro, and many other currencies, falling further against the dollar while interest rates futures were on the march as were bond yields across the world. 

Let’s step back in time and go over the events leading up to the mini-Budget on September 23 and the supposed market  “crash” which sent Truss and her chancellor, Kwasi Kwarteng, spinning into outer space. (This is not to defend the budget by the way: while most of the individual measures were sound, it was badly timed, ill-thought through, not properly costed and arrogantly executed.)

Over the summer months the price of gilts in the UK had been steadily falling and yields were rising. Traders were trying to exit: the sale of 30-year gilts was running ahead of selling in US Treasuries and German bonds throughout August. 

It’s likely that the selling was prompted by the announcement by the Bank of England at its Monetary Policy Committee on August 4 that it would start selling bonds – otherwise known as Quantitative Tightening – worth around £10 billion pounds a quarter from September.

This was the formal kick-off to the first round of QT, the formal unwinding of the £844 billion gilts bought by the Bank during the Quantitative Easing programme after the 2008 crash and which doubled in value during the Covid pandemic.

While there was market chatter about a bond bloodbath – not just here in the UK but across the West – trading in August is typically thin and more volatile because markets are less liquid than usual, due to the holiday season. This explains why such stories may not have made the headlines in the same way that they might usually do.  

This new round of QT was confirmed at the Bank’s MPC meeting on September 22 – delayed because of the Queen’s funeral – when interest rates were put up by 0.5%, and not the expected 0.75%. 

After that meeting, all eyes were focused on the rate rise but in the bond markets sharper eyes were fixed on the MPC’s unanimous vote to cut back on its stock of UK bonds by £80 billion over the next twelve months, to a total of £758 billion. 

This, said the Bank, was in line with the strategy set out in the minutes of the August MPC meeting and that QT would start through a mix of active sales and “not reinvesting maturing gilts.” That last bit is crucial.

As the Bank’s statement said: “At its August meeting, the MPC had communicated that it was provisionally minded to commence gilt sales shortly after its September meeting, subject to economic and market conditions being appropriate. At this meeting, the Committee agreed that the conditions were appropriate, and voted to begin the sale of UK government bonds held in the Asset Purchase Facility shortly after this meeting.”

It’s this little noticed statement which bond traders really took on board on that Thursday, the day before Kwarteng’s Friday mini-budget. As one bond trader put it to me: “Trading in the longer dated gilts was already fragile but after Thursday it became more so and the selling started in earnest.”

“What happened on the Friday – coming with the budget- was that all hell broke loose, particularly among the pension funds who could see what was happening to them. Truss was caught by this pincer: bit like a man being kicked when he is already down,”  he said.

The crunch came on Monday, September 26, when the price of 30-year gilts started falling sharply. Over the following days gilt prices plunged by 23% – in some cases even more sharply while yields shot up to 5%. 

In response to the chaotic conditions that Monday, the governor, Andrew Bailey, said the Bank was monitoring the repricing of UK assets: that’s central banker code for red alert. 

By the Wednesday, the Bank had swooped into the gilts market with an emergency rescue package promising to spend up to £65 billion over two weeks to prop up prices and buy what was necessary, particularly in the long-dated bonds whose prices crashed and where yields were shooting up.

It wasn’t said publicly at the time but the reason the Bank of England moved so swiftly was that several big pension funds with defined benefit schemes were close to collapse because of the higher gilt yields. They were on the edge because so many of them had hedged their gilts portfolios in Liability Driven Investments which, when faced with higher interest rates, meant they had to put up cash to cover margin calls. Many didn’t have the cash to settle the contracts.

As I wrote that week, one of the main drivers behind this market chaos was the fragile state of the pension funds and their LDI derivative contracts. And the reason why the pension funds had gorged on gilts was because the regulators – including the Bank of England – had encouraged funds to expand their gilts portfolios over the last few decades because it meant the government could borrow more and cheaply. Whether the Bank had deliberately turned a blind eye to the huge leverage being built up in these derivative vehicles or didn’t understand what was happening is still to be resolved. But there had been many alerts about the dangers lurking in the LDI market, both from players in the market as well as strong warnings made directly to the Bank by the boss of retailer Next.  

So is Kocherlakota correct in blaming the Bank of England rather than the so-called financial markets ? In his article he claims that the fall in gilts had little to do with the Truss budget but other factors outside her control: “Most of this (gilts) decline had nothing to do with rational investors revising their beliefs about the UK’s long-run prospects. Rather, it stemmed from financial regulators’ failure to limit leverage in UK pension funds.”

“These funds had bought long-term gilts with borrowed money and entered derivative contracts to the same effect — positions that generated huge collateral demands when prices fell and yields rose. To raise the necessary cash, they had to sell more gilts, creating a doom loop in which declining prices and forced selling compounded one another.”

It’s that doom loop again. And who is behind allowing the conditions for allowing such a doom loop to occur ? Well, the regulators at the Bank,  the Pensions Regulator and the Financial Conduct Authority.

Which is why the Bank, the institution responsible for overseeing the financial system, bears at least part of the blame for this catastrophe, he claims. And it is because of that regulatory failure that the Bank had to step in with the emergency gilt operation, which sent the financial markets into meltdown, triggering the narrative that the Truss government was causing economic Armageddon. By not extending the support operation beyond October 14 – leaving pension funds hanging, sorting out their portfolios – the Bank went on to compound the government’s mistakes because it left the markets open to even more fear-mongering and innuendo.

You might ask what’s the point of going over this now? That we are where we are: Truss and Kwarteng have disappeared. There is a new boys team in town – it’s all hunky-dory between the Treasury and the Old Lady again- and the markets have calmed down. The pound is back up and yields are down. 

Well, there are at least three vital reasons for wanting to understand more precisely what happened over the last few months leading up to the so-called market collapse. First, for the sake of accuracy and for the work of future historians as they record events. If reporting is the first draft of history – and it is badly off kilter – then the historians will be wildly wrong. 

Secondly, the way that the short-lived Truss era has been eradicated within a day or two might mean that any debate over supply side reform – and its impact on growth – gets thrown into the dustbin. That would be tragic. 

Thirdly, we should know what has happened in the interests of democracy and whether lessons can be learned. Kocherlakota is right when he claims: “The way the Truss government collapsed should concern all who support democracy. The prime minister was seeking to fulfil her campaign promises. She was thwarted not by markets, but by a hole in financial regulation — a hole that the Bank of England proved strangely unwilling to plug.” We should know why.

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