Schrödinger's Britain

The last time inflation in the UK sat at double digits, McEnroe was slaying grass volleys (and the umpire’s dignity) in his jockstrap briefs at SW19. The Bank of England was maneuvering rates around 600bps above the RPI. Today rates are 700bps below.

This might sound like a good time for the BoE to squeeze some liquidity out of its quid-soaked economy. Instead, policymakers announced a £45bn tax cut, an energy subsidy, and a buying spree of at least £65bn in long term government paper. Blimey.

That doesn’t sound right. Why on earth would they expand the money supply in this market? That too, two days after announcing planned sales of £70bn in gilts over the next year — with the market expecting rates to eventually hit 6%.

Which is exactly kind of stuff you should be doing (and arguably more) in such an environment. Just what are they smoking over in jolly ol’? This impromptu expansionism was apparently an “emergency measure” taken to protect pension funds and stave off a wider recession.

It was misguided nonetheless. Lets pedal back to what’s been happening in the UK’s bond market. Specifically with the Government’s long term paper — the 30 year gilt. The gilt is an established volatility shelter. Yields usually nudge a few basis points a day at most. Which is why conservative pension funds park a lot of their cash there.

Recall the term gilt-edged — meaning reliable and secure. A few days ago, the 5 year gilt yield popped by more than 50bps. That gilt-edge became sharp enough to slice up your nest egg like a California divorce.

Why did this happen? Yields had been rising in line with central bank rate hikes across the board and passed 400bps about a week ago. Then, HM Treasury announced a budget that played like a bagpipe at the London Philharmonic.

A contradictory fiscal stimulus that spooked investors right out of Blighty’s money market. If UK policymakers are so willing to disharmonize fiscal and monetary policy, they might has well have jumped on the Euro bandwagon 20 years ago. This is pressing your feet down on both the accelerator and the brake. It gets you nowhere.

Specifically, this caused a liquidity crisis in the large pool of Liability Driven Investment Funds (LDIs) which hold around £1.5 trillion — two thirds of which are invested in gilts. LDIs are used to hedge the risk on liabilities of pension funds.

Pension funds typically hold bond portfolios which need to service future payments owed to retirees. These stretch well into decades (just ask the Japanese what a pain in the ass that can be).

Gilt yields and inflation expectations directly dictate the present value of said liabilities. The assets hence have to be leveraged or hedged to be able to match those obligations.

Firstly, LDIs juice these bonds to fund liabilities through leveraged Repos: Buy gilts — collateralize said gilts — buy more gilts with the proceeds-— rinse — repeat.

Source: Insight Investment

Secondly, LDI’s hedge these liabilities through the use of interest rate swaps. For example, swap out the floating repo rate to fix borrowing cost. Swap rates dictate the cost of hedging.

When gilt yields spiked, swap rates did too. Asset values fell. Margin calls kicked in forcing liquidations. Pension funds began dumping gilts - pushing yields even higher. More margin calls. More liquidations. And around again. The spiral began to eat away at all those retirement contributions.

When gilts puked, despite the pall of crushing inflation, the BoE decided they had to act. To restore “financial stability” and quell the reduction of credit flows to the economy. Which, funnily enough, is exactly the opposite what was on the docket days earlier.

The emergency pivot worked in the immediate term. Yield on the 30-year gilt tumbled a full percentage point. This is however quite likely a stopgap. It just buys time for banks to shift gilts off their books leaving pension funds to eventually eat the losses when bond prices fall again.

That is unless the BoE continues buying bonds, which may well mean doubling down on a tailbone shattering landing.

Source: Blackrock

So let’s sum up where all this untidiness leaves the financial markets:

1. The UK has effectively resurrected QE while inflation sits at 10% and Europe’s energy burden is fast approaching 10% of GDP.
2. It is not implausible that other European states will follow in a similar reactionary pivot when key components of their economies inevitably begin to tumble.
3. Across the pond a hawkish agenda endures. The pointy end of the Fed’s rate hiking stick doesn’t seem to be deflating anything. So, the impetus remains to keep its foot tight on the gas.
4. Hence, there is startlingly little standing in the way of the dollar devouring all before it. We may soon be calling it the Ounce Sterling.
5. Swathes of capital will presumably flow out of European money markets and seek (a) safe havens or (b) suitable risk assets to capitalize on the bullish itch of Bernanke’s babies.
6. But, European equities are completely arseholed on account of godawful continental infrastructure and Herr Putin (not to mention his latest Rambo-esque infantryman Edward Snowden).
7. US equities remain subdued by the Fed’s stance. Real estate is illiquid, bubbly, and being slowly enveloped by the amoeba of adjustable rate mortgages.

And right in the thick of these events:

Blackrock — the worlds largest asset manager and go-to institutional fiduciary with $10 trillion in AUM — just opened another door to crypto in Europe…

• Two days ago a new iShares European blockchain ETF was announced.
• A similar ETF was launched in the US earlier this year.
• In August, Blackrock teamed up with Coinbase to integrate crypto into its proprietary trading platform.
• Also in August, it launched a spot BTC and spot ETH private trust for institutional investors.
• Blackrock joins JP Morgan, Fidelity, Aberdeen, Citi, Nomura and a host of other heavyweight legacy firms in launching digital offerings, with more following every day.

Now it should be noted this does not represent a zero-sum windfall for crypto. The majority of this escapist capital will likely flow into US money markets (or potentially EM bonds where there are trade surpluses — though conventional wisdom suggests emerging markets warrant no more than a quarter of any portfolio).

Source: Blackrock

There is also the matter of continuous downward pressure on bond prices. It is still unclear when this will abate. The Fed has no stated terminal target rate. Simply the aspersions of Lord Chairman toward the Chimera of inflation which, apparently, he shall slay or die trying.

Funds that may have sought equities in this situation will be taking a longer, harder look at crypto. And big brother Blackrock will offer an establishment-grade lens.

There is another dark horse of a thesis to consider — the difference between market sentiment and market sentiment.

The former being an aggregation of the market positions of market participants reflecting some composite of available economic metrics. The latter being this niggling feeling that markets are just waiting for a good reason to buckle like Do Kwon’s rebasing algorithm.

Central banks caked the economy in so much cash, a once-in-a-century virus couldn’t gobble its way through. Bucks thrown around like simian fecal matter. More unicorns, centi-billionaires and trillion dollar shops than ever imagined.

Then came a full on war with tanks and bazookas not seen since proto modernity. The only thing worse than Putin winning this fight is the idea of him losing. If and when the jig is up, he goes down swinging thermonuclear warheads.

Plus there’s the giant panda perched atop some empty Shanghai office building like Kong peering across the Taiwan Strait. While holding a balloon filled with about a $ trillion in US Treasurys. The mother balloon looking more like the Hindenburg holding $30 trillion against rising rates.

And just wait till Trump joins the festivities.

You get the feeling that somewhere, a Chernobyl is bubbling. Some asset class somewhere — like US housing in ’07 and tech stocks in ’99 — is ready to combust and set everything ablaze.

Every time market participants get a glimpse of the apocalypse, some of the negative sentiment crosses the divide into full-on distrust in the system itself. Capital carrying that sentiment has been spilling into crypto for years.

Consider then that this has occurred exclusively during a bull market. Crypto has yet to meet a recession. Practically, its too volatile to be seen as anything but a risk asset, despite it’s essence as a macro hedge. The former reality has outweighed crypto’s raison d’etre thus far.

Alternatively, Michael Burry is busy scooping up farmland with his reaper scythe. Planting wheat and building a bunker to store PAMP bars. He’s usually wrong for a couple years before he banks big. Or if you believe Elon Musk — he’s a broken clock. It is an extraordinary time. He may be onto something. But perhaps he’s looking in the wrong places.