UK not OK
Market shock should warn the government: think harder about economics
It says quite a lot about what the international capital markets think about the UK government and its economic policy when they start treating Italy with more respect. Especially so on the day that a far right political party with its roots in fascism wins the Italian election.
Whereas Italian 10 year bonds widened by 20bp to 240bp on Monday, UK Gilts shot out by 50bp, on top of sharp moves the previous Friday.
The Bank of England hardly settled stomachs when it announced in the evening that it would wait until its next scheduled monetary policy meeting on November 3 before deciding what to do next, ruling out an emergency rate rise.
Many of the UK’s problems are not unique. Most of its G20 peers face similar terrors: looming recession, a super-strong dollar, out of control inflation and aggressive interest rate rises. But that makes the speed with which UK capital markets have slipped into crisis all the more shocking.
The trigger was the “fiscal event” delivered on Friday morning by the new chancellor of the exchequer Kwasi Kwarteng. While he and prime minister Liz Truss described it as a bold bid for growth a “a new approach for a new era”, the markets have been running scared ever since, whollly unconvinced by their plan to fund £45bn of tax cuts and energy bill subsidies with a huge increase in borrowing that will pushing up annual Gilt sales to £300bn.
The mini-budget cued a mini-sterling crisis. The next two weeks will determine whether it develops into a full-blown currency crisis.
As an experienced Gilt market participant told GlobalCapital on Monday: “It is the first time I have ever seen the market collectively indicate a complete lack of confidence in the government itself.”
Sudden and vast increases in borrowing requirements are nothing new for the UK. The Covid crisis demanded a big response, including the extensive furlough programme and additional support for health services. That caused the 2020-21 net financing requirement for the Debt Management Office to swell from £156bn to £485bn.
On that occasion, markets, initially spooked, quickly got back into line. Sovereign debt sustainability was not an issue — partly because investors were convinced central banks would be there for them.
This is a very different time, although it seems to have escaped the new chancellor.
Markets have been febrile since Russia invaded Ukraine in February. They have become increasingly strung out as inflation has soared, energy costs have skyrocketed, and central banks have responded by aggressively raising rates, even as economies have slowed down.
In the UK in particular, bond investors are concerned about a widening fiscal deficit, a deepening current account deficit and flatlining growth.
Despite this, Kwarteng showed no anxiety that markets might be looking for reassurance that the government had control of its costs. On the contrary, he doubled down on team Truss’s tax-cutting schtick by pulling an extra giveaway out of the bag — scrapping the top 45% rate of income tax.
Maybe he thought bond markets had become so used to higher sovereign borrowing that the old economic orthodoxy about debt to GDP ratios had fallen out of fashion.
Or perhaps, six years after the Brexit referendum, he felt that the UK’s quest for freedom justified him going his own sweet way with the public finances.
He may also have forgotten that the Bank of England was about to embark, finally, on quantitative tightening, just as he was going to flood the market with £70bn more Gilts over the rest of this financial year.
The UK Debt Management Office has a superb reputation in the primary market and prides itself on a smooth and unflappable approach to bond issuance and navigating often unpredictable global fixed income markets. It’s a hard-won respect that has been forged in tough times, including the recent Covid crisis.
But Kwarteng and Co pose a new type of challenge to this reputation. Skilled management of debt issuance can do a lot to burnish a government’s fundraising programme, optimise liquidity and ultimately save basis points.
But the percentage points have to come from economic policy. Vision is all very well — but finance ministers need market confidence too. Kwarteng is about to discover that this, too, can take years to build up — and moments to spoil.
Today's Gilt syndication will be an early indication of just how worried the primary market is about this reputation.
This article was written and published before the Bank of England's Gilt purchasing intervention on Wednesday September 28. Please visit our Sterling crisispage for all our latest coverage on this topic