UK financial markets went into full-blown crisis in the last week of September following a BoE base rate increase coupled with the announcement of sizeable new deficit borrowing. The pound dropped precipitously against the major currencies and Gilt yields went abruptly higher. Severe dysfunction in one segment of the fixed income market led the BoE to step in to buy long-dated Gilts. Will this turmoil precipitate a long-term doom loop or is it a temporary phenomenon where the market is demanding a short-term increase in risk premiums?
As with many other developed countries, the United Kingdom (UK) is facing high inflation driven by sharp energy price rises, which led to the Bank of England (BoE) tightening its monetary stance. In turn, mortgage rates have risen in line with Gilt yields. Rising mortgage rates and high energy prices led to a sharp drop in consumer confidence and hence to concerns about economic recession. In addition, a relatively large current account deficit makes the UK a substantial net overseas borrower.
Against this relatively febrile backdrop, the new Liz Truss government announced a mini budget featuring deficit-financed tax cuts (1% of GDP) alongside a £60 bn energy price support package (2.4% GDP). However, should energy prices rise materially further, the two-year government-financed energy price cap may materially expand expected fiscal and current account deficits, requiring an ever-larger risk premium in the form of higher interest rates and a weaker currency.
UK financial markets reacted harshly to the mini budget, sending the pound down 8.1% and 5.5% against the US dollar and the euro, respectively. At the same time two-year Gilt yields surged by 1.7% while 30-year yields jumped 2.06% as margin calls on levered fixed income investors resulted in disorderly selling, which ultimately forced the BoE to intervene to stabilize liquidity through long-dated bond purchases.
Despite this turmoil, the pound finished September down only 0.8% versus the US dollar and both 2- and 10-year Gilt yields were only 60-70 basis points higher compared to levels on 22 September, the day before the budget announcement. Could this mean that the sharp market sell-off and numerous headlines warning of a severe permanent shock to the UK economy and the pound were short-lived overreactions?
Figure 1: Cheaper Pound and Higher Interest Rates an Opportunity?
The additional volatility and downside risks over the near term make sense given current domestic and global challenges and heightened policy uncertainty. In our view, however, this is a repricing of risk premium and not a massive permanent negative shock to the UK economy, UK assets and the pound. In other words, we do not think that the UK is headed for a doom loop of continually rising inflation and debt that permanently shifts the pound significantly lower or results in a dangerous upward spiral in yields to levels that threaten a default and a possible balance of payments crisis.
The idea that the UK economy and asset markets are in for a very bumpy ride over the coming months and quarters is not controversial. We expect global financial markets to remain volatile and the policy uncertainty in the UK to sustain as the government plans for additional fiscal measures. The Office of Budget Responsibility is expected to issue its assessment on the sustainability of current measures by end-month. The BoE faces tough policy choices as higher debt and high inflation have to be weighed against recession and further falls in the pound if UK interest rates lag those of the US.
In this environment, we think a move lower in the pound versus the US dollar to the 1.05 range is very likely and the risk of a move to parity or below is rising, though this likely requires another perceived policy misstep. Once the BoE steps back from its temporary intervention to stabilize the long end of the yield curve, we would expect rates to once again move higher, perhaps reaching the 4.75%-5% level across the curve.
The bigger point of contention among investors is the longer-term outlook. We do not think that the UK is headed for a doom loop of continually rising inflation and debt that permanently shifts the pound significantly lower. Neither do we expect a dangerous upward spiral in yields to levels that threaten default and a possible balance of payments crisis. Investors appear hyper focused on the obvious negative aspects of the fiscal plan while ignoring the reasonable parts.
Higher interest rates resulting from higher government debt may crowd out more private investments and consumer demand than what the tax cuts encourage. However, policies to support the supply side are a crucial component of raising long-term potential growth, and a 3%-5% increase in fiscal deficits for the next couple of years is hardly catastrophic. As the budget itself points out, the UK’s gross debt/GDP is the second lowest in the G7 (Figure 2).
Figure 2: UK’s Net Debt/GDP High But Manageable
Longer term, lower taxes should help to attract businesses and individuals looking for enterprise-friendly homes. Other initiatives in the budget such as free enterprise zones, efforts to expand green and fossil-fuel based energy supplies, reforms in electricity pricing, among others, are net positives over the long run.
If the current market pessimism is correct, the current account deficit, inflation and maybe the policies themselves should change for the better. Key to this is the market pricing a 5.9% peak BoE policy rate by next May. That is a huge tightening of financial conditions, which would probably cause a deep recession. A recession extending well into 2023 would likely act to quickly reduce inflation and the current account deficit as savings rates increase and import demand drops.
It would also put tremendous pressure on the Conservative Party facing elections in 2024. Therefore, if the market proves to be right about the powerful BoE response, there is a high probability that the government will walk back on some of the policies that have caused this sell off. In fact, Prime Minister Truss and Chancellor of the Exchequer Kwasi Kwarteng made a U-turn on the proposed elimination of the top 45% tax rate just ten days after announcing the tax cut. This proposal was small and has little impact on the total planned tax cut, but it highlights the possibility of a further softening of policies.
To be sure, our defense of the longer-term outlook does not necessarily mean that the current repricing of the UK rates and the currency is going to be transitory. We would be surprised if the BoE reaches the near 5.9% peak rate priced in by May 2023. The overall result would be modestly more persistent inflation than desired, which should push the fair value of the pound versus the US dollar down toward the 1.40-1.45 range from its current level of 1.52.
Even if we are overly optimistic and the long-term fair value of the pound drops to 1.30-1.35 on the back of further alarming policy announcements, there is still chance of a good 20% upside in the pound over the next 3-5 years. An additional premium in yields is likely to be a bit longer lived. A structurally higher real yield on UK debt makes sense due to the current account deficit, somewhat stickier inflation and elevated debt levels.
Overall, we see continued fragility in UK yields and the pound over the upcoming quarters with a significant risk of a deeper recession than expected. However, we see the bulk of the move lower in the currency and equity markets as well as the rise in rates as a temporary increase in risk premium, which means a higher future expected return rather than any permanent impairment. For that reason, we think the turmoil over the near term creates buying opportunities for patient investors.
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