UK turmoil shows how market stress can amplify policy errors

Amid global uncertainty, deteriorating market liquidity could pose risks and amplify shocks, as in the case of the UK mini-budget, which sparked a gilt sell-off and pound plunge
The war in Ukraine is the primary source of uncertainty but developments such as the US tech war on China could add pressure and financial market volatility

Tai Hui

Published: 4:30pm, 21 Oct 2022

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The annual meetings of the International Monetary Fund and World Bank typically come with volumes of research on the global economic outlook and assessments of financial stability. Most of the world’s economic challenges are well documented, indicating that slower growth, high inflation and tighter monetary policy are expected to extend into the next year.

In the latest Global Financial Stability Report, the IMF offered an important reminder that deteriorating market liquidity could pose risks and amplify shocks. The recent market turmoil in Britain is a good example of how a policy error could lead to unforeseen market volatility and economic impact.

It should be said, the architecture of the global financial system has been reinforced since the 2008 global financial crisis. With banks reducing their risk exposure and a stronger capital base acting as shock absorbers, central bankers have more tools to ensure financial stability. The US Federal Reserve was quick to introduce various funding facilities in March 2020 when the start of the pandemic led to an increase in bond market volatility.

Still, just because we have seat belts and airbags does not mean we can drive recklessly. Shocks and their agents of transmission often come from areas few anticipate. A good illustration is the recent market turbulence in Britain.

The country’s financial stress began with the newly installed government announcing a series of fiscal measures to boost its long-term economic growth. But it was unclear how the tax cuts could be funded. This mini-budget had also not been independently assessed by the Office for Budget Responsibility, which further undermined its credibility.

All these weakened investors’ confidence in the government’s fiscal discipline and raised concerns that inflation could be fuelled further by tax cuts. This led to a sell-off in UK government bonds, also known as gilt, and the British pound in the past weeks.

A man pulls down a banner held by two protesters as Britain’s Prime Minister Liz Truss makes a speech at the Conservative Party conference at Birmingham’s International Convention Centre on October 5. Photo: AP

Following this trigger, pension funds became the transmission mechanism, as their investment structure was not designed to cope with such high volatility in the government bond market. The Bank of England had to intervene in the bond market to avoid a further “fire sale” of gilt by pension funds.

After the financial turbulence and substantial backlash, Liz Truss – who has just resigned as prime minister – appointed Jeremy Hunt to replace finance minister Kwasi Kwarteng, and much of the tax cuts and pro-growth initiatives were reversed. This helped to calm the market as gilt yields declined and the pound rebounded. Yet these financial indicators have yet to return to the pre-mini budget levels, indicating that some of the damage has not been reversed.

This episode is a good example of an event that could set off a chain reaction in financial markets, be it investors’ scepticism towards a policy decision, a geopolitical event or even extreme weather.

With inflation still elevated and “sticky” due to the energy crisis, the cost-of-living crisis in many economies is forcing governments to take immediate action to reduce the impact on businesses and households. Although these measures are necessary to help everyone get through the winter, the scale of fiscal support and their source of funding will be scrutinised by investors. Populist governments trying to be too generous with public money could face pressure from market forces.

The financial warnings piling up should jolt us out of our complacency

The Russia-Ukraine conflict is still the primary source of global economic uncertainty. Further developments could lead to investors being even more risk averse. Developments in the US-China relationship, such as recent US restrictions on the exports of semiconductor products and equipment to China, could also bring additional pressure to the global economy and supply chain, which can translate into financial market volatility.

Ultimately, the global financial system has been living in a low-yield environment in the past decade. The Federal Reserve and other central banks in developed markets are tightening monetary policy at an incredibly fast pace, and they have vowed to do more in coming months to combat inflation.

Financial markets need to relearn how to live with higher rates and tighter liquidity. Ideally, this transition should take place when there are no surprises to stress the system. Yet in today’s complicated world, surprises are popping up everywhere, either by design from policymakers, or by accident.

Tai Hui is chief market strategist for the Asia-Pacific at JP Morgan Asset Management

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