How one woman tore down the British economy

I arrived in the UK a few weeks ago. What a month to put boots on the ground, huh?

My first few days, Queen Elizabeth was lying in rest in Westminster, where thousands of people queued to give their final farewells. The wait time eclipsed 24 hours at times. I saw one person call for medical attention – dehydrated and hungry; fatigued.

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Two days before her death, the Queen anointed another Elizabeth as the Prime Minister of the UK, in one of her last acts. Elizabeth Truss- more commonly known as Liz – had served as Foreign Secretary under Boris Johnson. Now, she had the biggest job in town.

Boris Johnson had resigned earlier in the summer, but stayed in office for two months while a new leader for the Party was found. Truss was that leader.

Unlike other countries I have spent time in this year – Colombia, El Salvador, Ecuador, to name a few – the British public did not elect their leader. Well, that’s not entirely true. A portion of the public did; in fact, Truss was elected by 0.26% of the public – a band of Conservative Party members.

I tried to ascertain the demographics of this group, but I found it difficult to come by. The best I could do was this quote from Tim Bale, professor of politics at Queen Mary University, who told the Financial Times that “older, well-off, white southerners may be a wee bit of a caricature, but it isn’t very far from the truth”.

This was confusing to me. I have spent the bulk of the year in Colombia, a country that went to the polls to elect its leader while I was there. To me, that felt normal. I suppose Colombia is weird though – they like empanadas, reggaeton music and, apparently, democracy.

But anywho. Let’s talk economics. This is the weird and wonderful 44-day reign of Lizz Truss – and how the path of the UK economy has been changed immeasurably – and why the pound is far from out of the wood yet.

Mini-budget

Let’s set the scene. We are a few weeks into Truss’ reign, and the UK economy is creaking.

The UK balance of payments (a log of exports minus imports) is at record levels. The energy crisis is in full flow as Russia continues its war in Ukraine. The UK, being reliant on energy imports, is struggling as a result. There are warnings of blackouts on cold evenings during the winter to come.

The pound has been crushed all year. Inflation has hit double digits, with investors fleeing for the US dollar. As tends to happen during recessions and times of uncertainty, the dollar is flexing its muscles as the world’s premier safe haven asset (I recently put together a case study on why we live in a dollarised world here).

Not only that, but higher interest rates from the Federal Reserve mean investors are flooding into the UK to take advantage of the higher yields on offer.

And then, Truss comes out and announces a budget cut. And guess what? The pound tanks.

To quote every essay I wrote back in secondary school, pandemonium ensues. Analysts are calling for dollar/pound parity, something I analysed as it was happening – with Bloomberg’s option pricing model slapping a 26% chance of parity on dollar/pound parity within six months. Wtf.

And then comes the pension concerns. The sell-off in the bond market is so severe that pensions, who match their liabilities with government bonds, are forced to make margin calls on those bonds because their value has plummeted so much.

In order to make these margin calls, of course, they need to sell those same assets in order to raise cash – leading to more margin calls, more selling and the definition of a death spiral.

Barely a minute into Truss’ reign, Google searches of the phrase “is my pension safe” rocket to the highest since the Great Financial Crisis (anytime you see the phrase “since the Great Financial Crisis”, you know it’s not a good time).

Enter the bank of England, jumping in to clean up the mess and act as a stopgap to buy the bonds. A fat bill of £838 billion was the end result, with the BoE having since announced a delay of the sale of these until the market turmoil calms down.

As I wrote about while this was going down, it is hard to understand the motives of Truss and co – and it just seems…baffling. In a high inflationary environment, with the domestic currency getting hammered and sentiment dipping, an aggressive and unfunded budget plan is the last thing you want to announce.

It’s essentially a deterministic relationship. You cut taxes in this environment, and bonds and the currency will sell off. And yet, this somehow wasn’t foreseen by Truss and her administration. One and one equals two – just like unfunded tax cuts in a high inflationary environment with a weak currency will cause confidence in that economy and currency to weaken even further.

Bonds and the pound melt down

Perhaps Truss thought the UK was a big enough economy, now standing alone in this post-Brexit era, that it could take the fight to the dollar and tell the world it was the captain of its own ship. That is my only theory. Even so, that is fantasy thinking, as the market showed.

There is no bigger symbol of a loss of confidence in an economy than a tanking domestic currency and creaking bond market. To have both bonds and the pound sell off so violently – and in conjunction – is terrifying for the UK economy. It is also largely unprecedented – a turn of phrase that I am getting tired of writing.

Will the pound recover?

The pensions always were – and are – going to be OK. That amounted to a liquidity crisis, and the BoE were duty-bound to step in and shore things up. But that doesn’t mean there is no lasting damage.

The bonds are still a problem. What happens when the BoE finally releases this £838 billion war chest in the market? Is the liquidity there to absorb this sum?

Regarding the pound, it bounced back up after Truss realised how grave an error she made. She threw her Chancellor under the bus – having assured the public he wouldn’t go – and walked back all the changes. Then she resigned (having also assured the nation she wouldn’t. But hey, let’s keep this to economics).

The pound now treads at $1.12, down 18% on the year against the mighty greenback. So, what next?

Well, this is the problem. Lizz may have walked, but her mess remains. The worst of the damage is to credibility. The UK has taken an absolute haymaker from her, and it’s going to be very difficult to get back on its feet.

Anyone who follows my work knows how big a fan I am of the below chart. In plotting the dollar historically against recessions (using the two negative quarters = a recession definition), you can see how much the dollar strengthens as the world wobbles. Stay with me, because it’s relevant to all this.

Like I said, investors flock to safe-haven assets in times of uncertainty. Correlations go to 1 in a crisis – there is a sell-off of anything and everything. And where do they go? To the safest assets in the world. And there is nothing safer than the fabled greenback.

Credibility

It’s a credibility thing. Money is a societal construct. It carries no intrinsic value – it is merely a piece of paper with a weird building on it, or some old politician. Or a dirty piece of copper that we call a coin. More often than not these days, it’s just a number a screen.

That is what makes money so fascinating. We assign it a value, a collective agreement that it has worth, allowing us to buy milk, bread, land, and crunchy peanut butter. Therefore, it is only as valuable as we decide it to be. It’s not like gold, or a house, which carry real value; tangible assets.

This is where the US dollar has excelled. Dating back to the Bretton Woods conference during World War II, the US has run the world – and that world has transacted in US dollars. It is the global reserve currency; we pay for our energy in dollars; developing countries are forced to borrow in dollars; everybody around the world knows the value of the US dollar.

But what about other currencies? The rise of the Chinese yuan has been foretold for a while, but that hasn’t really happened. The yen is all over the shop, recently hitting an all-time low off the back of monetary policy more aggressive than Raphael Varane’s tackle on Callum Wilson last weekend (Old Trafford decisions…).

The euro was meant to take the fight to the US – the European Union joining together to launch a common monetary union. The problem there, however, was the oversight of how difficult it is to have a common monetary union but different fiscal policies.

While the Germans are desperate to hike rates and cull inflation, the Italians have a fat debt bill, vulnerable to a dirty recession if rates are hiked and the interest rate payments climb too high. Sure the whole thing nearly imploded during the eurozone crisis, and now one dollar is officially more valuable than one euro.

So, the dollar has reined supreme. And as long as it survives, it prospers. The image is self-enforcing because of what we said above – money is assigned value by us as a people; it is not worth anything intrinsically.

This takes us to the biggest hammer blow – the credibility hit to the pound. Who is holding it now, as the UK hurtles towards another leader, its budget reversed, its Bank buying bonds like there is no tomorrow, and the National Grid forecasting winter blackouts amid the energy crisis?

The US runs the world

My overall thesis here has not changed. The economy is in absolutely dire shape. The money-printing bonanza of the last few years has released an inflationary beast that is hungry, and needs to be fed.

We knew this day was coming – and now it’s here. It’s time to pay the piper. Cue interest rate hikes, tanking stock markets, liquidity flowing out of the system and a world of pain. That was the predictable part – something which was evident by staring at the below chart (another of my favourites!):

What wasn’t predictable was the war in Ukraine. This has impacted the energy market significantly, which has hurt the energy-importing countries – of which the UK is one – badly. With the dollar already strengthening due to the recession sparked by the aforementioned variables, the mooning energy prices have made it a hell of a lot worse.

But Lizz Truss took office 44 days ago. This was happening all around her. Somehow, she didn’t see it. And although her time in office amounted to nothing more than a cameo, this impact will be lasting.

Because she has damaged the credibility of the UK economy and the pound on the international market. And that is a doing that won’t be undone for a very long time. The UK is not strong enough to take the fight to the US. It is not strong enough for unfunded tax cuts. These are privileges it has not earned.

Yet Truss grasped for them anyway. And investors punished her for it, first in the form of a collapsing pound, then a bond market melting down. At the worst possible time – when the UK is looking to establish itself as a strong, tier-1 economy, capable of excelling now that it has left the EU and is free to spread its wings.

And so, I fear for the pound and the UK economy at large. I see no way the pound bounces back up to previous levels (it opened the year at $1.35!). Things are ominous for the UK as a whole, as the temperature drops and winter creeps ever closer.

Things were bad before Truss’ chaotic 44-day term. Now they’re worse.

Lizz Truss may be gone, but her legacy remains, as the economy wobbles desperately. Strap in for a tough winter in the UK.