The Name's Bonds: Selling, Bonds

Data out this week showed investors are abandoning European stocks at a pace last seen during the eurozone debt crisis ten years ago. Apple, meanwhile, is reportedly not increasing production of its new iPhone range because of weaker-than-expected demand. In the crypto world, NFT trading volumes have tumbled. But, without a doubt, the biggest story of the week was the volatility and drama surrounding British markets after the government announced a series of tax cuts the week before. That caused the pound to tumble, led to a major selloff in British government bonds, and forced the Bank of England to eventually intervene. Find out what happened exactly in this week’s review.

Macro

Britain's drama started last Friday (23-Sept) after the Chancellor of the Exchequer, Kwasi Kwarteng, announced a series of tax cuts that threaten to further fuel inflation – already at a four-decade high – and balloon the nation’s debt. Those fears sent the pound tumbling more than 3% on Friday to hit its lowest level against the dollar since 1985.

What’s more, the tax cuts – the biggest since 1972 – are set to cost as much as £161 billion over the next five years and will be financed by government borrowing. That comes on top of the huge amount of extra debt needed to fund the prime minister’s recently announced plan to freeze households’ energy bills. Needless to say, a massive borrowing spree at a time when interest rates are rising sharply is not a good combo. That prompted investors to also dump British government bonds, sending their yields surging (five-year and ten-year yields, for example, posted their biggest one-day jumps on record).

The sell-off in UK assets went into overdrive on Monday after Kwarteng, in a television interview over the weekend, doubled down on the government’s stance and hinted at even more tax cuts to come. At one point on Monday, the pound had tumbled almost 5% to hit a record low of $1.035, taking it closer to parity with the dollar. Traders think such an outcome is inevitable, with the market-implied odds of dollar-parity surging to above 50% at the start of the week.

The plunge in UK government bonds, meanwhile, sent 10-year yields above 4% on Monday for the first time since 2010. The crisis raised calls for the Bank of England (BoE) to intervene, with some traders betting that the central bank will deliver emergency rate hikes to stem the pound’s bleeding. But a BoE statement on Monday did little to assure traders, with the central bank saying it will only adjust interest rates at its next scheduled meeting. That caused the pound to reverse some of the intraday recovery it was staging on Monday afternoon.

The BoE was eventually forced to intervene on Wednesday, but not in the currency market. Instead, the central bank attempted to rescue the bond market and avert a catastrophe for the UK’s pension funds. It did this by pledging to buy unlimited amounts of long-term government bonds, causing 30-year yields to post their biggest drop on record on Wednesday.

You might be wondering what pension funds have got to do with all this. See, with bonds collapsing, pension funds (which hold truckloads of the asset) were facing huge potential losses – especially on “liability-driven investment” strategies meant to give them exposure to long-dated assets to match long-term obligations. Pension funds started receiving a lot of margin calls, which is when brokers ask for more cash as collateral to cover those potential losses. If pension funds had started selling off investments to raise the necessary cash, it would’ve further hit bond prices and led to a downward spiral that sank the market altogether. A worse outcome is if pension funds couldn’t meet their margin calls, which would’ve caused them to go broke and hit millions of Brits’ hard-earned pensions. So the BoE had no choice but to intervene.

Amid this week’s chaos, many traders likened the UK to a developing country, pointing to the combo of a falling currency and rising government bond yields. The crazy thing about all this is how the country’s policies are contradictory in every sense. The BoE, for example, is hiking interest rates to lower demand and tame sky-high inflation. The government’s tax cuts, however, have the opposite effect: they likely will lead to increased consumer spending and higher inflation. Making matters worse, the BoE’s emergency actions this week – buying unlimited amounts of long-term government bonds using newly minted money – are set to flood markets with cash and could add more fuel to the inflation fire. How the drama will end is anyone’s guess…

Stocks

Investors are abandoning European stocks at a pace last seen during the eurozone debt crisis a decade ago. According to Citi, European equity funds are on track for eight straight months of outflows totaling $98 billion, or 6% of their assets under management (AUM). That means cumulative redemptions are now worse than the pandemic-led selloff in 2020 and are comparable to the 2011-12 eurozone debt crisis. But for contrarian investors, this could actually be a buy signal. That’s because in previous cases (except the 2008-09 global financial crisis) when outflows hit 6% of AUM, the MSCI Europe Index subsequently gained 16% over the next 12 months, according to Citi.

In other news, Apple – the world’s biggest company by market value – is reportedly backing off plans to increase production of its new iPhones this year after an anticipated surge in demand failed to materialize. According to unofficial reports, the tech giant has told suppliers to pull back from efforts to increase assembly of the newly launched iPhone 14 product family by as many as 6 million units in the second half of this year. Apple’s shares initially fell 4% on Wednesday after the news broke out, which also hit shares of its key suppliers.

Crypto

NFT trading volumes have tumbled 97% from a record high in January this year. According to data from Dune Analytics, NFT trading volumes slid to just $466 million in September from $17 billion at the start of 2022. The fading NFT mania is part of a wider, $2 trillion wipeout in the crypto sector as aggressive monetary tightening around the world inspires investors to ditch the most speculative assets like crypto, expensive stocks of unprofitable tech firms, NFTs, and so on.

Next week

Earnings-wise, next week is a quiet one but that’s the “calm before the storm” if you will, since the third-quarter earnings season is due to begin the following week. On the macro front, the week will start off with PMI data from a number of major economies. Japan reports September inflation data on Tuesday. OPEC+ is meeting on Wednesday, and traders will be looking to see if (and by how much) the group of the world’s biggest oil-producing countries and their allies cuts oil production in a bid to prop up prices. We’ll get eurozone retail sales on Thursday and, finally, the closely watched US jobs report on Friday.