Sterling fell for the fourth day in a row on Friday, taking the pound to a 14-month low at the end of a brutal week on the markets which analysts blamed on a “perfect storm” created by Chancellor Rachel Reeves.
The UK has been among the markets hardest-hit by a surge in global borrowing costs, which most analysts say originated in the US due to concerns about rising inflation, reduced chances of a drop in interest rates, and uncertainty over how president-elect Donald Trump will conduct foreign or economic policy.
Sterling has lost 1.5 per cent on the week, gilts underperformed peers and domestic focused stocks also struggled.
British assets remained under pressure on Friday from elevated global borrowing costs, as gilt yields rose for a fifth consecutive day, with better-than-expected US jobs data intensifying the moves. The pound fell 0.75 per cent against the dollar and hit $1.2194, surpassing Thursday's low.
It has led to concerns the chancellor will need to reduce spending or raise taxes to avoid breaking her fiscal rules.
Reeves under pressure
While higher yields can sometimes support a currency, they are not in this case, in part because they are putting pressure on Ms Reeves, potentially forcing her to cut future spending.
Former Bank of England economist, Stuart Cole, feels Ms Reeves created the “perfect storm for herself” by talking down the prospects for the UK economy almost as soon as the new Labour government took office last summer. “The UK economy, as former Bank of England governor [Mark] Carney himself made clear, relies on the 'kindness of strangers',” he told The National. “International investors buy gilts and provide the finance for much of the government's spending and the last thing they need to hear is a message that all is not well in the country where they are placing their money.”
Labour has repeatedly blamed the previous Conservative government for leaving a £22 billion hole in the country's finances. In its first budget, the new government set out a series of tax rises and planned borrowing it believed would stabilise the economy, but which has so far served to dent business confidence, caused wages and recruitment to stagnate and failed to stimulate growth.
Ms Reeves has also faced criticism for pressing ahead with a trip to China aimed at seeking closer links with Beijing as part of an attempt to grow the economy. The Tories accused her of “fleeing to China” while the economy at home came under huge pressure.
“There remains clear concern over the likelihood that all of the Chancellor's fiscal headroom has now been eaten up by the sell-off in gilts, and the anaemic nature of UK economic growth,” said Michael Brown, strategist at Pepperstone.
Deutsche Bank said in a note on Friday that investors should sell the pound on a broad trade-weighted basis, and that there might be “further to go” in the recent pound weakness.
Taking a pounding
The pound's losses came despite reaching highs not seen since 2016 only a month ago. Some of the turnaround of sterling's fortunes is down to persistent inflation worries in the US, leading to forecasts that the Federal Reserve will keep interest rates higher for longer, which provides continuing strength to the dollar.
But analysts shrugged off the worst predictions that sterling could plumb depths not seen since the aftermath of the mini budget under Ms Truss when the pound touched $1.0327, its lowest point since decimalisation in 1971.
Even so, economists feel the combination of the falling pound and rising gilt yields does raise red flags for the UK, given its fortunes are much more reliant on international money flows than other major economies. As such, often the UK government has fewer options to stem bond and currency crises, and is more at the mercy of international markets. “The more a country relies on foreign financing for its domestic debt issuance, the more exposed it is to the global environment,” Deutsche Bank's currency strategist George Saravelos told clients. “From the perspective of external flows, the UK is one of the most vulnerable in the G10.”
But in many ways a weaker pound may actually be more of a help than a hindrance. It makes UK assets more attractive to foreign investors and can stimulate inward capital flows, which would go some way to closing the current account deficit. However, the flip side of the coin is that prolonged sterling weakness might be inflationary (because import prices rise), which could mean the Bank of England keeps interest rates higher for longer – not an ideal situation for a Chancellor who is desperately looking to grow the economy out of its troubles.
“Higher borrowing costs and a weak currency hardly speak of market faith in her growth plan and fiscal targets,” Mr Mould told The National. “However, a weak pound could be part of the solution. It makes UK assets (including gilts) cheaper and more attractive for overseas buyers, and it makes exports more competitive (and imports more expensive) to help boost growth, and help to balance the current account which, like the fiscal account, is in deficit.”
Turmoil in the UK's government bond market and the fall in the value of the pound has reinvigorated concerns among economists about the level of inflation in the British economy and the speed at which interest rates may be able to move lower this year.
Inflation concerns
Concerns over the state of the UK’s stretched public finances combined with persistent inflation fuelled this week's sell-off and drew comparisons with a market meltdown two years ago that toppled the Liz Truss administration.
“The Bank [of England] hasn’t dealt with inflation yet,” said Erik Britton at Fathom Consulting. “Inflation has fallen but the second-round effects are still in play. Private sector wage growth is unsustainably high. Bond markets are saying that longer-term inflation has slipped from the Bank of England’s grasp. They must address that to restore the credibility of inflation targeting.”
Last month, Bank of England governor Andrew Bailey hinted that four quarter point reductions lay ahead this year but markets are currently pricing only two cuts to 4.25 per cent by December. “The wiggle room for the bank is now much narrower, especially if we don’t get further fiscal consolidation,” Nora Szentivanyi, JP Morgan global economist, told Bloomberg this week.
UK inflation started to rise towards the end of last year, up 2.6 per cent in November, the second consecutive monthly increase. That, combined with figures that showed the UK economy essentially flatlined in the third quarter of last year, raised fears of a stagnating economy: no or low growth and rising inflation, which makes cutting interest rates a more difficult task for the Bank of England.
As such, for Russ Mould, investment director at AJ Bell, the stickiness of UK inflation creates a dilemma for the Bank of England and a continuing headache for UK Chancellor Rachel Reeves. “The Bank of England maybe wants to cut [interest rates] to boost growth, but maybe cannot cut as fast as it would wish, owing to inflation,” he told The National. “Growth is needed and baked into the Office of Budgetary Responsibility (OBR) GDP forecasts upon which Ms Reeves’s taxation and spending plans are based. The fear is that growth does not come through, forcing either spending cuts or tax increases to reassure bond vigilantes, with a further knock-on impact upon growth – and so on and so on, in an uncomfortable circle.”
Tax changes
In many senses, the fear of inflation never went away, but came roaring back into the minds of traders after the festive break. A survey by the Bank of England this week showed companies plan to raise their prices by 4 per cent this year, because of the increase in employment taxes announced in last October's budget.
In addition, worries that to balance the books and not break her own fiscal rules Ms Reeves would have to raise taxes, cut spending or increase borrowing set alarm bells ringing and yields on some UK gilts soared. Nominal 30-year gilt yields hit their highest level in more than 25 years, while 10-year yields rose back to 2008 levels. Markets and the financial press were awash with comparisons to the fallout from the ill-fated Liz Truss/Kwasi Kwarteng mini-budget and even the situation in 1976 when the then-Labour government had to call on the International Monetary Fund (IMF) for a bailout.
On Friday, Culture Secretary Lisa Nandy played down the market events of the past week. “It's obviously something we take very seriously but these are global trends that have affected many countries, most notably the United States, as well as the UK,” she told Sky News. “We are still on track to be the fastest-growing economy, according to the OECD [Organisation for Economic Co-operation and Development] in Europe.”
Fiscal headroom
Nonetheless, there remained concerns that the fiscal headroom calculated at the time of Ms Reeves's budget last October was rapidly being eroded by the extra cost of borrowing, as gilt yields sustained their upward track. The OBR forecast a budget surplus of 0.3 per cent of national income, or about £10 billion ($12.25 billion), over the next three years. Number crunching by the Institute for Fiscal Studies (IFS) found that if relevant gilt yields rose by only 0.5 per cent (which is true on the 10-year gilt over the past month) for a sustained period, that would add £8 billion to the cost of government debt. It's the main reason the IFS at the time of the budget referred to the headroom as “razor-thin”. “There remains clear concern over the likelihood that all of the Chancellor's fiscal headroom has now been eaten up by the sell-off in gilts and the anaemic nature of UK economic growth,” said Michael Brown, a strategist at Pepperstone.
That probably means more cuts to public spending lie ahead, according to Richard Hunter, head of markets at Interactive Investor. “The additional costs of borrowing, to which the UK is particularly exposed, presents another potential headache for the Chancellor,” he told The National. “Given the fiscal rules and the draconian measures announced in the budget, the shortfall which the government now faces means that a reduction in public sector spending has become much more likely, rather than any further tax hikes which would further infuriate the populace.”
Some analysts are pinpointing an increase in the supply of bonds as part of the problem. In the budget, it was announced the UK Debt Management Office would look to sell £300 billion in gilts, up from a previously predicted £277 million. “That increase in gilt issuance helped to revive long-held market preconceptions about ‘tax-and-spend’ Labour governments and bond investors are clearly concerned about the UK government’s overall debt pile and interest bill, especially as a good portion of the bonds sold to fund that borrowing are index-linked, so the coupon, or interest rate, goes up as inflation goes up,” Mr Mould told The National.
'No intervention'
As gilt yields rose and the pound fell, the chief secretary of the Treasury, Darren Jones, told parliament there was “no need for an emergency intervention” amid cries from opposition MPs that Ms Reeves was “missing in action”, a reference to the fact that she had gone ahead with a planned trip to China, along with Bank of England governor Andrew Bailey, on Thursday.
Not alone
Analysts, however, have been quick to point out that the UK is not alone in this bond market sell-off. “Government bonds have sold off across the developed world, led by those in the US,” said Ruth Gregory, deputy chief UK economist at Capital Economics. “This seems to have partly reflected growing concerns about Trump’s policies and in particular his willingness to deliver more tax cuts despite the already poor prospects for US public finances. The 10-year yield in the UK is now a bit higher than in the US but nothing outstanding by past standards.”
Indeed, economists at the Bank of America noted that Ms Reeves is unlikely to break her own fiscal rules by borrowing to finance day-to-day spending and spending cuts are more likely than tax rises. “In our view, the chances of breaking or changing the fiscal rules are slim, given the government's commitment to fiscal stability,” they said. “We think it is much more likely that the government announces fiscal consolidation measures to meet the rules and restore the headroom. Consolidation is possible in spring or earlier (potentially via spending cuts) and perhaps more meaningfully in the autumn. We think the bar for the Bank of England to intervene in the gilt market is high and comparison with the mini budget is overblown.”
