How Liz Truss still haunts markets

Every time government bond prices dip, one name comes up: Liz Truss.

The former UK prime minister, whose brief tenure failed to outlast a supermarket lettuce, has not assumed a George Soros-style role. She is not running a fund with the power and guts to make or break the world’s most respected monetary authorities. 

But her lasting gift to financial markets is this lesson: if you play silly games in bond markets, you win silly prizes. Her poorly received fiscal plans in the autumn of 2022 brought the gilts market to the brink of disaster, catapulted the UK’s pensions industry into chaos and sent ripples across global markets.

This still-fresh memory is now an enduring cautionary tale. No other government wants its own Liz Truss moment. 

In the US, the Congressional Budget Office has sounded the alarm. Back in March, CBO director Phillip Swagel said that the US fiscal burden was on an “unprecedented” trajectory, name-checking Truss as an example of the “danger” inherent in sparking abrupt market reactions.

So it was again this week, when a shaky auction of US government debt shoved bond prices lower, and therefore yields higher, unnerving holders of other asset classes in the process.

Wednesday’s eye-catching debt auction was not a disaster, but it was not the usual smooth process either. Underwhelming demand for the $44bn in new seven-year notes meant that so-called primary dealers — the big banks that make Treasuries trading tick, stepping in to make up any shortfalls — bought 17 per cent of the debt, somewhat above the norm.

In itself, that might not have drawn too much attention. But the previous day had also brought lacklustre demand for two- and five-year debt. Put together, and mixing in some broader doubts over the willingness of the Federal Reserve to cut interest rates this year after all, it was enough to push benchmark US 10-year bond yields up to 4.63 per cent, the highest point in a few weeks. Stocks also took a knock.

“Trussing up Treasuries?” asked Paul Donovan, chief economist at UBS Global Wealth Management. “Equities were a little upset because bonds were a little upset because of weaker demand at a US bond auction. Should investors be upset?”

It is certainly possible to construct an argument that this is another early skirmish in what, in the years to come, could become a brutal battle between the US government’s borrowing plans and the markets.

The numbers sound scary. At the end of the fiscal year 2023, the amount of outstanding US debt was equivalent to almost 100 per cent of gross domestic product. That is set to blast higher in the coming years, bursting through second world war levels in 2029, and will stretch up to 166 per cent by 2054, the CBO projects.

Making matters worse, borrowing costs are higher now that the Federal Reserve has jacked up interest rates to tackle inflation. Interest costs will hit 3.3 per cent of GDP in 2025 — the highest since 1940, the CBO said. Thirty years from now, the federal government could be spending a third of its revenues on interest alone. “The nation is on an unsustainable fiscal path,” the Peterson Institute says. 

Given all this, it’s easy to see why bond investors might demand higher yields on US government debt — or back away from auctions for fear of a wave of new bonds. 

Ronald Temple, chief market strategist for Lazard’s asset management business, says he is pretty relaxed about the US interest rate outlook and the resilience of stocks. This fiscal situation, however, is his “single biggest concern on the US economy”, and one that he does not see changing.

“I don’t see it as a Liz Truss moment,” he said. “It’s more of a frog in a boiling pot. That to me is why the market should be cringing every time we see these auctions. Auctions should be on everyone’s calendar as a risk factor.”

Some perspective is important here. This week’s wobble was just that — a wobble. Treasuries, the most important financial instruments in the world, are not in meltdown or I would have mentioned that somewhere higher up in this column. And for every investor who is convinced the system is doomed, there’s another who thinks the whole thing is an exaggerated fuss. 

At this point, the market has not activated any of the tripwires that turn a bond shock into a broader threat to financial stability, as Truss’s “mini-Budget” did when the slide in bond prices kicked off an ugly chain reaction in an arcane pocket of leverage in the pensions industry. True shocks are, by definition, impossible to predict, but no such mines are obvious at this point in the US system.

“This is not a US version of the UK’s Truss debacle,” Donovan at UBS concluded. “Markets are not disorderly and government policies are not destabilising.” Nonetheless, as he says, this is all likely to remain a “background worry”. The risk of an accident is real, in the long term. For now, we should all learn to live with frequent hiccups in the months ahead.

katie.martin@ft.com