The ominous tale of what happened in the UK economy in September

Recently, the UK's 10-year government bond yields or gilt yields jumped exponentially high, which is unprecedented in developed nations. Not just that, many interesting things happened within a very short time in the last week of September, all of which are equally ominous.

On 23 September, the finance minister announced a massive tax cut of £45 billion, which is "unfunded," meaning there is no plan or direction regarding how the government can afford to forego that tax money. Not only that but the government is also expected to provide subsidies on energy costs, both to households and businesses, amounting to £150 billion.

But ultimately, the government needs more debt to fund the tax cut. 

On top of that, the Bank of England is already on the path of selling £40 billion of bonds within a year as part of their quantitative easing programme. According to a Deutsche Bank forecast, the UK government needs to sell at least £250 billion of bonds within the next couple of years. So, the market is expecting to see a massive surge in the supply of gilts or UK government bonds soon. In that case, the gilt prices are bound to fall with relatively lower demand.

Another issue that makes the yields rise is the expectation of higher interest rates. The government is bound to increase interest rates at higher rates in the coming months to fight inflation, further lowering the demand for existing bonds with lower interest rates and sending the current yields to the moon.

That is why, immediately after the announcement of tax cuts, we have seen one of the most massive rises in yields in the history of the developed world, one that is only comparable to developing nations.

Another issue is that the sterling is losing its value against the dollar at a much higher rate. A major factor is the relatively low rate of increase in interest rates in fighting inflation. Among developed nations, the UK has some of the highest inflation (around 10%). A key source of such rising inflation is the UK's relatively high dependence on inefficient sources of energy.

Compared to other European nations that fulfil a greater share of their energy demand from nuclear energy and renewable resources, the major share of the UK's household energy is fulfilled by natural gas. The UK is, next to Italy, the most inefficient consumer of alternative sources of energy in Europe.

Due to the lower-than-expected increase in interest rates, investors are getting their money somewhere else, mostly in the US, to get a higher rate of return. This is especially true in the UK because it has a rather high inflation rate, which lowers the real interest rate. How could investors operate in such an inflation-adjusted environment with a low rate of return? The combination of higher prices of imported physical goods and a higher demand for foreign financial assets made the demand for the sterling pretty weak. This was true for many other nations fighting inflation.

Another important development is the UK government's reversal in quantitative easing policy starting from 28 September, which came right after their announcement of tax cuts. Why such a reversal of policy on an emergency basis? A big part of this issue is the UK's huge pension liabilities problem.

The total amount of UK pension fund liabilities is around £1.5 trillion. That is almost two-thirds of the UK's GDP. We know there is a negative relationship between the present value of pension liabilities and discount rates. There is an estimate that every 0.1 percentage point fall in the yields of UK government bonds leads pension liabilities to increase conservatively by £23.7 billion. How to manage such interest rate risk? Bonds are a good way to hedge the interest rate risk of pension liabilities. If interest rates go down, pensions liabilities go up. On the other hand, bond values go up as well. However, holding bonds are operationally complex, expensive and subject to limited supply.

A more flexible strategy is an interest rate swap, where one party can get a fixed interest rate by paying a variable interest rate to the other party. A pension fund manager can arrange an interest rate swap contract, let us say for 10 years, receiving a fixed interest rate and paying a variable interest rate to a counterparty over those 10 years, making the pension liabilities out of exposure to changes in interest rates. The expectation is that the total value of fixed interest rates to be received by the pension funds will be equal to the total values of variable interest rates to be paid by the pension funds over the lifetime of the swaps.

The problem occurs when long-term interest rates start to rise. In that case, the pension funds have to pay higher variable interest rates than the fixed interest rates they receive. But if interest rates fall, the swaps generate value for the managers. If interest rates go up rapidly at faster rate, the funds start to lose money as well. In that case, they need to provide more cash or collateral to the third parties facilitating the swaps. In recent times, the funds had to sell their gilts for access to cash for collateral requirements. 

This is exactly what happened last week. When gilt yields started going up rapidly, the pension funds had to sell gilts to cover their losses in interest-rate swap contracts.

Going forward, there are two important dates, 21 October and 9 December. Those are the days that the UK sovereign debt rating will be reviewed by S&P, Moody's, and Fitch, respectively.

Dr Ibrahim Siraj is an associate professor of Financial Accounting at Long Island University, New York, USA.

Disclaimer: The views and opinions expressed in this article are those of the author and do not necessarily reflect the opinions and views of The Business Standard.