The Golden AirBag as "Economy Is Starting To Go Through The Windshield"

One of the many unintended consequences of a USD persistently rising as the Fed tightens is the pain it inflicts on the rest of the world. Not only does it effectively export inflation from the US to the rest of the world, it corners global central banks into following suit on aggressively raising rates or see their currencies continually devalue.  Last week the RBA ‘under hiked’ and now refer Exhibit A, an AUD in the 62’s.

However the EU and UK have a much bigger problem but have been forced to tow the line. Yesterday one of the EU chiefs, Spaniard Josep Borrell, broke ranks and spoke out clearly in defiance of the Fed accord.

“Everybody has to follow, because otherwise their currency will be [devalued]……Everybody is running to increase interest rates, this will bring us to a world recession.”

Both the IMF and World Bank are currently meeting to address this very issue. Yesterday the IMF warned frankly:

“The worst is yet to come, and for many people 2023 will feel like a recession…..As storm clouds gather, policymakers need to keep a steady hand.”

The UK, maybe more than most, is particularly vulnerable as it faces higher than most inflation, a poor economy, a large importer of goods (made more expensive by a lower Pound) and a pension scheme heavily leveraged in bonds that are, frankly, tanking. This is greatly exacerbated by a new leader trying to win favour and ease pressure on her new constituents through fiscal easing via energy price relief, growth enhancing reforms and of course those famous large unfunded tax cuts.  The competing forces of fiscal easing and monetary tightening are causing havoc.

The plummeting UK bond market, oft called gilts, has put enormous pressure on their pension funds as they get hit with massive margin calls on their leveraged ‘inflation hedge’ holdings.

Enter the Bank of England controversially stepping in with its emergency bond buying program to stave off an uncontrolled collapse.

Mohamed A. El-Erian is an eminently respected Bloomberg Opinion columnist, former chief executive officer of Pimco, president of Queens’ College, Cambridge and chief economic adviser at Allianz SE.  This is what he had to say on Bloomberh yesterday:

“The UK narrative is well known by now. A “government in a hurry” goes all out and promises not just protection from higher energy prices for both households and companies and growth-enhancing structural reforms but also large unfunded tax cuts. It does so in the context of a global increase in borrowing costs. Not surprisingly, markets push back strongly against the implied increases in the amount of debt, interest payments and debt-to-GDP ratio. The resulting sharp surge in yields exposes the significant fragility of a pension system that resorted to financial engineering to enhance returns.

Given the threat of financial and economic contagion, the Bank of England has no choice but to intervene in a manner contrary to its continuing mission to reduce high inflation. The government does a partial U-turn, but it’s not meaningful enough to improve the dynamics in play in a sustainable way. The resulting market calm quickly gives way to more turmoil, forcing an expansion of the BOE’s intervention.

It is tempting to think that the underlying market dynamics are limited to the UK. They are not. They risk extending in varying degrees to a growing number of countries around the world, including those traditionally viewed as the strongest, such as Germany.”

That is, this is a BIG deal.

Well last night that went up a notch when BoE’s Governor Andrew Bailey rather incredibly stated they will end this in 3 days..

“My message to the funds involved and all the firms is you’ve got three days left now,….You’ve got to get this done. The essence of financial stability, is that it (intervention) is temporary. It’s not prolonged.”

Markets tend not to respond well to such threats in the context of said lack of financial stability.  The problem the BoE has had with this whole program and hence the reaction of the Pound plummeting and bonds falling on the ‘threat’ is that few are taking up their offer to buy.  The mechanism is not attractive enough nor quick enough to offset possible losses compared to the open market should they reject the offer. From Financial Times:

“The way that the bank has structured this intervention is they can only buy assets if people put offers into them, but nobody is putting offers in,” said Craig Inches, head of rates and cash at Royal London Asset Management.

So where to from here?  From Reuters:

“UK pension schemes are racing to raise hundreds of billions of pounds to shore up derivatives positions before the Bank of England calls time on support aimed at keeping them afloat.

The Bank of England plans to stop buying bonds on Oct. 14, leaving pension schemes scrambling to meet a collective cash call estimated to be at least 320 billion pounds ($355 billion) without a buyer of last resort.

The central bank on Tuesday made its fifth attempt in just over two weeks to try and restore order in markets, after a surge in yields on Sept. 28 threatened to overwhelm pension schemes that had loaded up on leveraged derivatives.”

The problem is that it may force these massive funds to unload other global assets to meet the margin calls.  Again from Reuters:

“He [Hemal Popat, partner, investments at Mercer] estimates pension funds could sell assets totalling around 300 billion pounds as they adjust hedging positions, although it is not clear how much they may have sold already. He estimated 100 billion pounds could come from gilts and the rest from assets such as global credit, global equities and asset-backed securities.”

Already we are seeing selling pressure on global equities as central banks tighten into a recession and, post this deadline, we could see a lot more pressure on markets but also the more systemic issue of insolvent UK pension funds and what contagion that unleashes.

Last night we saw JP Morgan Asset Management’s CIO Bob Michels say on Bloomberg:

“When the central bank steps on the brakes, something goes through the windshield. The cost of financing has gone up and it will create tension in the system”

Soon after El-Erian reiterated:

“The economy is starting to go through the windshield, the financial system is starting to go through the windshield,”

There are few better ‘air bags’ to protect you than gold.

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