By CHRIS ILLING
As predicted in last week’s article, the inflation rate in the euro area has reached double digits for the first time since the introduction of the single currency. As the European statistical office, Eurostat, announced on Friday, following an initial estimate inflation was 10 percent in September. In August, it was still 9.1 percent. Bad news for the Euro zone, but it was an even worse week across the channel.
On Wednesday, the British central bank, the Bank of England, apparently prevented a financial collapse in the City of London with a spectacular emergency operation. The question remains, though: For how long? Several pension funds were said to be on the verge of collapse.
The decline in value of the British pound and UK government bonds, the latter whose yields had shot up to a record level of more than 5 percent on Wednesday, led to considerable upheaval in the London financial world. During the day, the UK’s entire pension system faltered, and several pension funds were reported to be on the brink of collapse.
After a dramatic drop in prices on Wednesday morning, there were simply no more buyers for long-dated British government bonds. Only the intervention of the Bank of England prevented a worse case scenario. The market for UK government bonds is dominated by large pension funds, which primarily act as buyers of the long-term securities known as gilts.
In the long run, lower bond prices and higher yields are good for pension funds because they help them to generate the necessary income for retirees. They try to protect themselves against inflation and interest rate risks with hedging strategies. In normal times, when gilt yields - the interest rates paid on government bonds - are rising, the funds may have to sell some of their assets to keep things in balance.
However, given the recent rally in government bond yields, the hedging strategies threatened to fail completely and make the situation worse. In the event of short-term, rapidly increasing risk premiums, as during last week, hedged positions must be backed with additional collateral. This apparently forced UK pension funds to sell assets in a hurry on Wednesday to stay afloat and meet their payment obligations. They also had to part with other bonds, which accelerated the downward spiral. Suddenly the system threatened to implode.
It was the new UK government that triggered the dramatic developments on the bond and currency markets. On Friday, five days earlier, the UK government announced a multi-billion dollar package of measures to tackle high inflation and boost the UK economy. The UK’s finance chief, Kwasi Kwarteng, announced both higher government spending and tax cuts at the price of rapidly increasing Great Britain’s national debt.
At the beginning of the week, the pound fell to a new all-time low (1.0358) against the US dollar and government bond prices fell. The situation worsened on Wednesday, so the Bank of England launched a £65 billion contingency plan. For the next 13 working days it now wants to pump £5bn into the bond market.
And, indeed, the markets for British government bonds recovered significantly after the central bank’s announcement. The pound strengthened against other currencies such as the dollar. On Friday, the exchange rate against the US dollar was at 1.1118 again.
The central bank intervention should now give pension funds time to replenish their collateral in an orderly manner and with less pressure. However, the temporary intervention has not permanently eliminated the UK sterling crisis and the turbulence surrounding British government bonds. Difficult times lie ahead for the new British government.