Sir Paul Tucker on Is the UK Suffering a Sovereign Debt Crisis?

On Thursday, October 6, Sir Paul Tucker joined Markus’ Academy for a lecture. Sir Paul Tucker is a Fellow at the Harvard Kennedy School and a Former Deputy Governor of the Bank of England for Financial Stability.

Watch the full presentation below. You can watch all Markus’ Academy webinars on the Markus’ Academy YouTube channel.

Timestamps:

[0:00] Introductory remarks
[10:21] Brief summary of the last decade of UK monetary policy
[19:18] Conundrum: an added risk premium with no change in inflation?
[21:15] Market Maker of Last Resort to Restore Market Liquidity
[35:11] LDI and Lender of Last Resort
[48:50] Exchange rates
[50:15] Key takeaways

Executive Summary

• [0:00] Introductory remarks. In the last few days, after the UK announced a “mini”-budget, the British Pound dropped, and interest rates on long-maturity the UK government bonds spiked, so the Bank of England suspended its Quantitative Tightening plan while it intervened as a market maker of last resort. Governments and central banks play a game of chicken to decide whether one ends up in a monetary or fiscal dominance regime. In addition, monetary policy might be constrained due to financial dominance. That is, monetary authorities might be hindered to fight inflation in order to avoid havoc in financial markets. In the UK, pension funds’ liabilities to pensioners are long-term and move in the opposite direction from interest rates; they hedged the re–evaluation risk (due to accounting rule changes in 2005) with interest rate swaps via Liability-Driven Investment (LDI) vehicles. As long-term interest rates rise, they enjoy only book profits without cash in-flows as the liabilities value declines. On the other hand, their derivatives positions lose in value, which triggers margin calls triggering cash out-flows. This forces them to sell off gilts. The big question is whether the current spike in UK long-term interest rate is due to funding frictions or due to fundamental solvency issues of the UK.
• [10:21] Brief summary of the past decade of UK monetary policy. Following the global financial crisis, interest rates have been low, and there have been four bouts of “quantitative easing.” Recently, following a mini-budget on 23 September, ten, 20, and 30-year nominal forward rates have risen a lot, with a lot of volatility. That long-maturity forward rates rose, and sterling’s exchange rate fell, prompted some commentators to suggest a sovereign-default risk premium had entered the sterling yield curve. If that were so, one would expect to see an increase in the wedge between nominal and inflation-indexed bonds, since any default would be more likely to come via monetization than legal default.
• [19:18] Conundrum: an added risk premium with no change in inflation risk? Looking at real and nominal rates can give an idea of the market’s estimates for the so-called “breakeven” inflation rates (which reflect inflation expectations plus any inflation risk premium). Yet, following the fiscal event, there was no shift in the 10- or 30-year breakeven inflation rates. If the market believes that there is a tangible risk of default, but inflation expectations and risk premia are roughly constant, the remaining possibility would be legal default, which seems highly implausible.
• [21:15] Market Maker of Last Resort to Restore Market Liquidity. Shortly following the fiscal event, the Bank of England stepped in through a Market Maker of Last Resort (MMLR) manoeuvre and announced gilt purchases, which for a while lowered long-maturity yields without making large purchases, perhaps by stemming forced sales.
• [35:11] LDI and Lender of Last Resort. More recently, the central bank has offered, via bank, a lender of last resort facility to LDI vehicles, presumably to help them meet collateral calls (by lending against their illiquid risk assets). This gives asset managers time to rectify the mess they have landed themselves.
• [48:50] Exchange rates. The exchange rate for the pound fell against both the dollar and the euro following the fiscal event but has recovered somewhat since the MMLR interventions.
• [50:15] Key takeaways. We cannot know exactly what is happening in the markets, and these indicators might reveal different things within days or weeks. It is necessary for governments to carefully articulate their fiscal frameworks and commitment to sound public finances over the long run. These issues are even more important than usual due to geopolitics. The West cannot afford another financial crisis, as discussed in Global Discord. Policymakers have dealt with many challenges, but this adversity can help reinvigorate efforts to build resilience for the future.