Forty-two years ago, this week in her conference speech the then Prime Minister Margaret Thatcher declared: "You turn if you want to. The lady's not for turning."
Liz Truss has already made one U-turn on the mini-budget’s proposal to eliminate the 45% top rate of tax and is under pressure from her own MPs to go back on much more of Kwasi Kwarteng’s budget.
Liz Truss may also look to Mrs Thatcher’s track record on tax-cutting. In those first 17 months, she had cut the top rate of income tax, but it was still 60% and there was an additional 15% on investment income. It had come down from 83% which meant the top rate of tax on investment income had been a seemingly absurd 98%. The abolition of the extra 15% had to wait until 1985, and the top rate was not reduced to 40% until 1988 when the economy was much stronger, and inflation had come down substantially. Mrs Thatcher understood the need for patience and balanced books. Kwasi Kwarteng presented huge tax cuts but will not explain how the books get balanced until the 31st October. His first mini-budget hit the bond market particularly hard.
Un-costed tax cuts caused a dramatic sell-off in the bond market. As discussed in my article last week, this was accelerated by pension funds’ leveraged Liability Driven Investments (LDI). The Bank of England (BoE) stepped in to buy bonds and provide liquidity. In the face of a further sell-off, the Bank also increased this facility to include inflation-linked bonds. In the previous week, the Bank had actually purchased relatively few bonds, but the message in itself had initially been enough to drive yields back down again. However, this Tuesday, the BoE Governor Andrew Bailley told pension funds they had until the end of the week (i.e. today) to rebalance their books, after which the bond buying would end. Pension funds will have found it hard to do it that quickly, but it is noticeable that since then the Bank has had to buy many more bonds. The message was no longer enough.
Pension funds calculate their liabilities using long-term interest rates. This has been made immeasurably harder by the huge recent intra-day swings in yields. The febrile nature of the bond market was not helped by reports that the Bank of England was going to extend its deadline being quickly quashed. Similar ones flowed that the tax cuts were next in line for a U-turn until the Chancellor denied them and suggested it was full steam ahead. Within 24 hours, 30-year UK bond yields had jumped to 5%, fallen back to 4.4%, and risen to 4.6%. At this pace, the sentences I’m writing might be overtaken by events even before their full stops.
Kwasi Kwarteng is now flying back from Washington DC, and it is possible that we could see another U-turn before the weekend is over (or perhaps before it even begins). He should remember not to make the blunder Jim Callaghan made in 1978 when returning from an overseas conference in the middle of the 1978/9 winter of discontent that led to the headline ‘crisis, what crisis?’ (Those were not his exact words but the headline the next day was all that anyone remembered). He consequently lost the 1979 election – to Margaret Thatcher, no less.
This is a very real crisis for many households. The government action on energy costs will be welcomed by many of the most in need, but the savings on this are dwarfed by rises in mortgage rates. If you have a £200,000 interest-only mortgage fixed two years ago at 1.3% your payments are £2,600 a year, yet if you are renewing today for two years you may face a rate of over 6% - or £12,000 a year! Many people will have larger mortgages than that. This cannot be good for the economy. The Chancellor may try and blame the BoE for rate rises but stimulating the economy when inflation is already high, means rate rises are inevitable. However, the Bank is not blameless and should have seen the systematic risk in LDI and acted to stop its growth, rather than waiting for the horse to bolt before closing the stable door.
Just over a month into her Prime Ministership, Liz Truss looks to be in considerable difficulty. To do another U-turn looks weak but the pressure to do so from her own party looks enormous. Another leadership challenge cannot be ruled out. The coming hours and days may see more volatility in bond and currency markets. Bond yields may be looking attractive but as the Bank ends its support, care is still merited, particularly for longer date bonds.
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