Truss Implodes

"My small expert group opined it's hard to overstate the size of Britain's financial challenges."

First, an admission. I don't understand economics or the financial market. Such is my ignorance of money matters; the wife doesn't trust me with paper money. Before the Octopus card, I walked around with a pocket full of coins. 

Against that background, for financial illiterates like me understanding what happened in the U.K. these past weeks is a struggle . Fortunately, plenty of folks with better brains are willing to educate me and express an opinion over a gin and tonic. Nevertheless, what Tom, Dick, Harry and Mike had to say was shocking. (Obviously not their real names —based in Hong Kong, each works or worked in the financial markets)

For starters, opinions on Truss ran from "She doesn't know what she’s doing", "She's blinded by a simplistic ideology", to "She's suffering from the Dunning-Kruger syndrome".

Mike struck a different tone. “She foolishly didn’t have a credible costing to balance the cuts, but I think she’s directionally right. Reducing 25% of the public sector by removing all woke jobs would be a good start. In just seven years, the Civil Service has increased in size by a quarter to almost half a million, yet the astonishing number of personnel hardly delivers extraordinary performance.” This produced nods of agreement.
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Meanwhile, a 'word salad' survey by the firm J.L. Partners identified the expressions most associated with Truss. ‘Incompetent’ topped the list, a close second is 'useless' and 'untrustworthy'. See above.

On the back of this, support for the Conservative Party collapsed. If an election is called today, the Tories face a total wipeout in London, Scotland and most Red Wall seats. The polls state they'd keep between only 50 and 80 seats.

That is a staggering fall from the 356 seats currently held, with a working majority of 69. Hence, last week's annual party conference looked like a wake. Truss has only been in the job weeks, yet is earning ratings lower than the ousted Boris Johnson.

My small expert group opined it's hard to overstate the size of Britain's financial challenges. Further, we came within inches of a global economic meltdown because of Britain's role in the broader world economy. 

As the new PM, Truss inherited a domestic economy at risk of entering a recession. In response, she delivered a "mini-budget" with more government spending and the largest tax cuts in 50 years. She wanted this to stimulate growth. Truss confirmed that she and her Chancellor decided much of the budget without consulting the Cabinet.

Neither did they approach the clever folks at the Office for Budget Responsibility. The OBR’s job to ask if the public finances are on a sustainable path. (Set up by Tory George Osborne as brake on high-spending Labour governments, the OBR may hamper Truss) 

Immediately after the budget, the financial markets asked an obvious question, "How will you pay for this when the U.K.'s budget deficit is already in the hundreds of billions of pounds?" The markets gave a prompt vote of no confidence as the bond market sold off, while the pound fell to record lows. 

Now things get a bit complicated. As bond prices fall, yields increase. It's not necessary to understand all the machinations here except to say for Britain's pension schemes to work, the interest rates can't rise too high too quickly. That's what happened. (Don't ask me why)

The pension funds faced the prospect of not paying pensioners because they lost too much money on their investments. To stop this, the Bank of England came in to buy up bonds on an enormous scale. This move increased the price of bonds and lowered the interest rates on those bonds.

These measures worked and brought stability to the markets. Also, Sterling went up. Yet, the Bank of England's bailout of Britain's pension schemes is limited.

Here's the problem. The Bank of England stated, "These purchases will be strictly time-limited. They are intended to tackle a specific problem in the long-dated government bond market. Auctions will take place from today until 14th October."

So, what happens when they stop buying? After all, the forces that led to Britain's financial system edging towards the brink remain in place. 

Sure, the Bank of England can keep coming to the rescue of the financial system. But this risks more inflation, which will lead to higher interest rates. Of course, Britain could allow the market to take over and risk a full-blown financial crisis when the bond market collapses again. 

Where does the U.K. go from here? Well, Truss has already reversed the tax cut. That helped reassure the markets because it generates income. But, the Bank of England's buying of bonds is only due to run until 14th October. Hence Truss will need to do more to calm investors before then or face another sell-off. 

Also, the rating agencies are due to assess the U.K.'s financial standing by the end of October. Last week, S&P cut the outlook for an A.A. rating to "negative" from "stable." So it looks like a downgrade is coming.

At top all this, the Bank of England must decide on interest rates by 3rd November. 

Tom explained, "Economies are complex, evolving systems that these days react fast to perceived risks. You can't drive through ideology against market forces because the markets will not fund your ideas unless you prove you can pay for them. Truss didn't do that. Whatever you think of the market's reasoning, the market dictates the interest rate at which the government can borrow." Which begs the question, what can she do? 

The consensus is that she has no easy options. Dick affirmed, "Having already imploded her credibility within her party and with the markets, she's between a rock and a hard place. She may need to pursue massive cost-cutting, but that would make the Conservatives unelectable."

Warming to this theme, Harry concluded, "The party will move against her, with the smart money on her removal sooner rather than later. That should buy them time to repair the damage before the next election; otherwise, they face the wilderness. I reckon Sunak will be back in some role"

​The Guardian, in a remarkably balanced article, sets out three possible scenarios for Truss. Take your pick.

Cheers. Anyone for a gin and tonic?