The UK financial system nearly broke this autumn when rising interest rates created a vicious circle of margin calls driving the stock market into free fall and with it a cycle of rising interest rates driving bond yields up causing further margin calls to the pension fund institutions.
This kind of hidden danger is just what causes crashes.
Pension funds had levered their government bond portfolios to the roof to reach for higher returns. Back in the day these same funds had been squeezed by the regulator out of stocks and into bonds so as not to risk to much risk in their funds and get into exactly the vicious circle they now found themselves in by turning safe bonds into mountains of dangerous leverage.
What irony! Well not really.
The thing is this, who is going to buy the bonds of a country up to its ears in debt with an out of whack fiscal deficit heading into a recession, let alone buy the bonds of a government locking down its economy because of a plague? Well your pension fund will with a little bit of encouragement and a blind eye from the government.
Thank heavens the regulators pension was half vested in this mountain of leverage because up they popped when the whole system was about to implode and promised to buy £60 billion of the collapsing mountain to prop it up and for that matter prop up the whole financial system.
They rescued the day. Good job too. (Lets not call it £60 billion of QE (£1000 a head for each brit))
So here we are today with runaway inflation in the UK and up goes interest rates by an expected 2.5% to 4%.
Meanwhile since the Bank of England stepped in up has gone the London market from a nasty trough toward an all-time high.
What went right?
What went right was this.
Rising interest rates equal falling bond values, exactly what broke the system last year. So how can interest rates go up much from here without a re-run of that vicious circle?
The answer is, no more or certain few further rises in interest rates.
This is what the BOE has telegraphed officially today and it would appear that the city has expected for a long time now.
….. but what about inflation???
Well tough luck everyone, we are going to have rather more of that than previously planned, more for longer.
This of course is what is needed to get GDP going back up and with a bit of luck deficits will fall back and things will get back on track and inflation can be squeezed out over a longer time horizon.
“Well, well, well” they will say, “those supply chain issues took longer to be fixed than expected and inflaton is tougher to fix than expected, but we are getting there.”
Remember the country is a lot poorer now than it was before Covid and until that reality is in prices and peoples standard of living, its not worked through the system.
What does this mean for UK shares?
The market is saying, it means up.
I say be very careful. Only buy the very best. Only buy shares with pricing power and very solid balance sheets.
This is a fragile setup, but interest rates are going to stay moderate, money loose, exchange rate soft and inflation fizzing a long. It will be bumpy but the market should up along side the cost of living.
Itsbound to be a rough ride with plenty of opportunities for the wheels to come of the UK charabanc.