The Bank of England 's actions surprised many observers. The Bank of England raised its interest rates by 50 basis points, but at the same time returned to quantitative easing as it began buying large amounts of British government bonds. How to understand this opposite step and how to interpret it? The events surrounding the British debt resemble a situation similar to the one that occurred in 2008. What exactly? Are we on the brink of a new major crisis?
In order to understand the current events, we need to recall the basic data. The bond market is the largest in the world in terms of volume, by a lot compared to the market for shares, gold or cryptocurrencies. This is due to the fact that debt is a fundamental engine of economic growth. Central banks and large institutions such as pension funds operate in this market . The factor of small players is completely negligible. As a result, the bond market is subject to strict, even mathematical, rules , and was highly sought after for its low volatility and stability. The bond makes it possible to value money conservatively. Its holder receives a coupon every year, which represents the interest on the borrowed money. The stability of the investment is mainly used for pension funds, which enable retirement savings by purchasing long-term bonds.
Each bond is rated by independent agencies such as Moody's, Standard & Poor's or Fitch Ratings , which assign grades to the bonds. The higher the quality of the bond, the more its yield falls. On the contrary, the greater the risk of bankruptcy, and therefore the failure to repay the entire debt, the more the interest grows. These agencies have a common postulate that the best bonds and therefore the best rated are the state ones. Unlike corporations, states go bankrupt quite exceptionally. Since the bond market is very complicated and abstract, let's get closer to how it works with an imaginary example.
It is Great Britain that has recently made several decisions, such as energy assistance to citizens and the abolition of taxes for the richest Britons , which are destroying public finances. Great Britain's debt thus jumped from pre-covid 82% to GDP to 95.9%.
The whole situation might seem clear. Pension funds will show big losses. If you're just about to stop saving for retirement and withdraw your money, you'll have to swallow a bitter pill. But that's not all. In essence, if a few funds failed, the market would clear and move on.
But the situation is much worse. Why? Since the investment strategists knew about the things described above, they decided to solve the whole situation earlier and deal with big investment companies like JP Morgan or Goldman Sachs to develop a special product that would protect them from going bust. What is an hypotactic Mr. Smith decided to insure his British bonds. Although it will cost him extra money like any insurance, he is protected in the event of a bond market crash. So the investment banker has to find someone to take responsibility for the risk. Therefore, the investment bank will make a derivative product , which it will sell to a customer willing to take the risk, and the latter will receive a portion of the insurance payment.
Just like in 2008, these financial products created by investment companies are so complicated that the end customer does not know exactly what he is buying. In the event of the collapse of the pension fund, he would have to bear its entire weight. Since it is not known exactly who these people are and how big a systemic crisis it would cause, it would mean the collapse of the entire system. The crisis would come from a direction no one would expect. The nature of a real crisis is precisely that it comes completely unexpectedly.
The Bank of England thus intervened to save the entire financial system, reducing yields by buying bonds. Of course, this will only support the current inflation. Rather than allow a new crisis, it decided to save the existing system under the slogan of capitalizing profits and socializing losses. With higher inflation, all British taxpayers contribute to the rescue of the financial system. There's no rational reason why Great Britain's situation hasn't reached Europe. It's just a consequence of the bad monetary policy of previous years. Lending money to someone for a long time at zero or even negative interest makes no sense. We'll now pay the price for this policy where capital had no value.