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  • Writer's pictureAllQuant

A National Debt Crisis - Ease Before Even Tightening?

We are now nearing the end of the 3rd quarter of 2022. Central banks around the world have stepped up their efforts to fight persistently high inflation by raising interest rates and embarking on plans to tighten the money supply. What happened today were seeds sowed by years of loose monetary policy and mounting national debts. And their resolve is now seriously challenged as nations try to grapple between helping people and businesses whose lives are buckling under immense price pressure vs taming sky-high inflation. To fulfill the former, the Government needs to spend more, and run and finance larger budget deficits through borrowings. This stokes inflation and is likely to elicit a response that will weaken their currency and send their borrowing costs even higher. And if taken too far, that can call into serious question the nation's ability to sustain its debt obligations leading to a collapse across its assets.

UK Blinked And Eased Before They Even Tighten

Yesterday, we see the first glimpse of the Bank of England (BoE) caving in under pressure from the UK Gilts market (UK Gilts are long-term debts issued by the UK government - the equivalent of US Treasury Bonds). Since the start of the year, UK Gilts have fallen as deeply as more than 30% before yesterday.

iShares UK Gilts ETF (YTD) (Source: Google Finance)
iShares UK Gilts ETF (YTD) (Source: Google Finance)

And the pound has also been rapidly losing its value and gaining speed despite the Bank of England's interest rate hikes. First, it was the Euro which is now trading below parity against the USD. Now, it is the pound. Not yet there, but very close. At its worst point, the GBP traded 20.7% below the start of this year (was even lower on intraday prices).

GBP/USD (Source: Google Finance)
GBP/USD (Source: Google Finance)

Apparently, the market was not too impressed with where the UK is heading in particular with its broad sweeping historic tax cuts announced recently. So yesterday, in an unexpected emergency move to stabilize the pound and UK Gilts, BoE bought long-dated bonds to stem the crash. And it declared its resolve by saying it will buy an unlimited amount of bonds to shore up confidence. Yes, this is a temporary measure. But you can call this by any other name, it is to me Quantitative Easing again. If they have gone according to plans, they were in fact due to tighten and start their bond selling program next Monday. This, however, has also been delayed to the end of next month for the time being.

Of course, the market rejoiced. UK Gilts ETF (Ticker: IGLT) did a spectacular reversal and rose to end the day up more than 7%. And it is not just the UK or its Gilts that benefitted. The hope of central banks easing has a contagion effect that extends its way to every corner of the world. Almost all assets globally rebounded strongly after being beaten down for the past few days. The US also delivered a stellar performance. Stocks, bonds, gold, REITs, oil, you name it.

Your Fate Is Tied To The Central Banks & Governments

While central banks and the government have always played a pivotal role in shaping the economy and the markets, it has never been more so in history. Because, unlike prior crises where debt issues came from the private sector, the debt problem today now sits on the public's balance sheets. We went one big round, the music stopped, and we are back again at the source. Whether the UK Government should have bitten the bullet and delayed introducing aggressive stimulus measures or whether BoE should not have intervened to prop up the market, is a hard judgment call. Everyone will do what they think, not what you think, is in their best interests. While this may present some relief to the market, for now, it is still too early to say that the tide has turned. Because the fundamental problems of why we are in today's mess are very much still there.

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