It’s the borrowing, stupid

28 Sep 2022

The rapidly falling pound sterling is, according to the opposition coalition of political and media commentators, proof that confidence in the three week old Truss administration is fading away. There are certainly plenty of economists saying that the chancellor’s tax cuts will not stimulate growth and that, whatever, it’s all not fair.

The Bank of England is probably wondering whether to raise the bank rate to defend sterling, though it will also be nervous that any indications of panic will make things worse. The gilts market is anyway taking the decision out of its hands. Two year government paper yields 4%. The Bank of England does not command the rates at which actual transactions take place in the real world.

I suggest that the Bank continues its policy of pretending to be a cork in a jacuzzi.

I have written many (many) times about the remarkable growth of UK government borrowing and how the costs were artificially disguised by the QE through which the Bank of England, as an agent of the Treasury, purchased gilts in the open market while the same Bank of England sold new gilts on behalf of the same Treasury. It really was as circular as that. It must be time to quote Lewis Carroll.

“But it’s no use now,” thought poor Alice, “to pretend to be two people! Why, there’s hardly enough of me left to make one respectable person!”

While QE was still in operation (until the end of last year) there was an implicit market agreement to see no folly, hear no folly and speak no folly. The wonder is not that the gilts market is being yanked back to reality now but that it spent so many years in a hallucinogenic stupor.

The Bank of England bought £445 billion of gilts to smooth over the fallout from the subprime crisis and Brexit and a further £450 billion to fund lockdown. Due to the fact that it drove prices up and paid top dollar it lost £112 billion on its transactions (a hundred billion here, a hundred billion there – whatever) which means, to be clear, that it lost that money on our behalf. And, to be even clearer, our great, great grandchildren will have to pay it back.

In March the official cost of serving the national debt in the fiscal year 2022/23 was estimated at £83 billion. After five months (April to August) the running bill was £44.4 billion and the estimate was raised to £87 billion. Given what has happened since August, that bill is likely to fly to the moon.

Our new problem is that after more than ten years of emergency borrowing the government has just (with almost universal support it should be noted) committed to borrowing much more to combat a new emergency (rising domestic energy bills).

The UK will not default because it borrows only in its own currency – the pressure valve from excess borrowing is devaluation which in turn feeds inflation and this in turn will devalue the debt at the expense of those who hold it – that’s us again, either directly or through those institutions that manage our pensions for us.

I cannot imagine what the institutions, other than the Bank of England, that bought gilts during the lockdown and furlough months were thinking of.

In June 2020 they paid a total of £4 billion at £1.09 for a 1.5% yield Treasury Gilt that redeems at £1.00 in 2026. This equated to a yield to redemption of 0.016%.

I bought that gilt myself yesterday at £0.897 yesterday for a redemption yield of 4.47%.

My investment may soon look foolish if inflation locks in above 10% for years to come. But at least there is a modicum of probability in my favour. Those who locked in for five years at 0.016% must have been suffering a mental fever which, as far as I remember, was not a recognised symptom of Covid.

So, the current market disdain for gilts is not in the least remarkable – it was probable and some might say inevitable. It is, in my opinion, a welcome and long overdue sign of sanity.

For an idea of what all this means to the Treasury’s mission to borrow in the future, here is a chart of the yield of one of its favourite gilts, the 0.3/8% due to redeem in October 2026. All the marked points on the chart are yields at which actual sales were achieved. The low point was 0.32% in August (whoever bought that, please stand so that we can all see who you are) but by April 2022 the yield had more than quadrupled to 1.52%. The government’s cost of borrowing was clearly on the rise.

4.2% is today’s yield. For the record, that’s a thirteenfold increase compared to April ’22. This is what faces the Treasury as it searches for lenders who will fund the unquantifiable energy subsidies. Our governments have been addicted to “emergency” borrowing since 2009. A dodgy idea is about to get a whole lot worse.