The U.K. Canary In The Federal Reserve Coal Mine

Miners used to keep canaries in their mines because the bird had very fragile lungs and when the air became toxic the bird would fall off its perch dead, long before the miners would start to collapse. This brutal but effective alarm system is now synonymous with the first signs of danger ahead.

Most realize that the global economic system is fragile, especially for countries that took on enormous burdens of debt to bridge the economic chasm of the Covid response. The resultant inflation from the money print-a-thon is now in the spotlight and the U.S. central bank is going all out to stomp it out. However, that boot heel is crushing all before it, including the currencies of the world economy, flattened by the U.S. interest hikes of the U.S. Federal Reserve. The dollar is a runaway train as many other countries are simply not politically ready or able to follow suit in tightening to keep up with the dollar’s bond yields.

The runaway train of the U.S. dollar was the “elephant in the room” but now it is trampling everyone, it is no mystery.

The U.K.’s recent aggressive budget would have normally been welcome, but the house of cards that is the global economy and the sovereign debt mountains that have been built everywhere meant that instead of a welcome for its stimulus, it created panic. This would have dissipated quickly but those wonderful people in financial services had a surprise in store. They, as they are wont to do, had loaded up on a toxic investment strategy that looked great when the circumstances were going their way but would collapse into catastrophe should the situation reverse. British pension funds had been taking their safe government bonds and leveraging them up into a fragile tower of debt to get more returns.

It works like this. Take the government bond you own and use it as collateral to borrow money and buy more governments bonds. Use the new government bonds as collateral to buy more government bonds. Do this till you can’t buy any more. This is most profitable if bonds rise in value, but you better hope bonds don’t fall in value because if they do you will lose the one bond you started with and maybe end up owing money too.

What could possible go wrong? Why, interest rates going up could spoil that picture and as every wild gambling pension fund runs screaming for the exit to sell, the whole country’s sovereign debt system, its government funding and its economy implodes.

Now this is just the sort of situation the mainly useless UK regulator should have spotted a mile away and years ago and said, ‘Don’t be silly, don’t do that,’ but no. Make no mistake, it is their duty not to miss this behavior and nip it in the bud.

So after a minor shock to the system from the U.K. chancellor, down came the avalanche of pension fund forced sellers. If you yodel in the Alps, bad things happen if that year’s snow is deep enough. So down came the mountain of debt and the Bank of England stepped in and saved the whole UK financial system from meltdown. This is still ongoing. Tomorrow is the drop dead date for the pension funds with a problem to be bailed out, but strangely there has been no stampede to get a bail out from the Bank of England. So much so the governor came out in public and told those affected they have till tomorrow (October 13, 2022) to do the trade or they lose the deal.

You can take this in two ways. The problem was smaller than expected so don’t worry, or the parties with broken bond portfolios simply can’t unwind them because the losses would be so horrendous the TINA (there is no alternative) is to shut up and hope interest rates reverse from a new regime of QE forced on the authorities by the prospect of pension Armageddon saves them.

Take your pick.

Yet little ole U.K. is not really the big deal.

The big deal is, if the U.K. pension funds have been up to this stupid trick, what about the European ones, the U.S. ones, the Japanese one, etc.? If this ridiculous trade is endemic around the world, like the credit trades of the world financial crisis of 2007-2009, then this is the start of a BIG ONE! 2008 was corporate and mortgage debt, this is sovereign debt! Sovereign debt is the 880lb gorilla riding the elephant in the room.

Tiny avalanches, make small avalanches, make big avalanches.

While it doesn’t have to happen, contagion is a monstrous risk that all investors have to watch for.

Pension funds leveraging up their sovereign bond portfolios is just a scandal and if it’s just not a Brit thing, we are in for a wild ride because ultimately the only way to fix that situation if it was endemic would be to rebase the currencies involved. It would be called a pension bailout but it would involve QE like we have never seen before and a disruption of sound monetary policy even bigger than the actions of the recent explosion of money supply.

If the U.K. is just the canary then the market will go into freefall.