“Financial markets express their faith – or lack of it – in a country” through its borrowing costs and the value of its currency, says Russ Mould of AJ Bell. In the UK, investors “do not like what they see”. On Monday the pound slumped close to its lowest level against the dollar in 37 years, trading as low as $1.14.
Rapid interest-rate hikes in the US have seen the greenback strengthen against most currencies this year – it recently hit a 24-year high against the Japanese yen. But sterling has done especially poorly of late. In August the pound lost 4.5% against the dollar, its worst monthly performance since October 2016, and also fell almost 3% against the euro.
The pound’s fall comes despite the fact that the Bank of England has been raising interest rates, a move that would normally strengthen a currency. “Until August, there had never been a month when sterling fell by as much as 4.5% against the dollar and ten-year gilt yields rose by more than 90 basis points,” according to data going back to 1971, say William Schomberg and Dhara Ranasinghe on Reuters.
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The fact that gilt yields are rising (see below) even as the currency falls “is indicative of overseas investors losing confidence in the UK”, says Mike Riddell of Allianz Global Investors. “I think the UK and the gilt market are in a degree of danger.”
A toxic cocktail
Traders are reacting negatively to Liz Truss’s proposed “cocktail of especially loose fiscal policy, attacks on the central bank and conflict with the EU”, says Hugo Dixon on Reuters. If she’s not careful “the pound could be clobbered”. Truss is not alone in wanting to spend more on the energy crisis, but the trouble is that the UK is especially vulnerable to inflation, says Ian Johnston in the Financial Times.
Core inflation is running at 6.2% here, compared with 4% in the eurozone. That means that “pound for pound, euro for euro, fiscal spending by governments will be more inflationary in the UK” than elsewhere in Europe, says Antoine Bouvet of ING. The UK’s large current-account deficit – which hit £44.2bn, or 7.1% of GDP, on an underlying basis in the first quarter – leaves it vulnerable to the whims of financial markets. The gap needs to be covered by foreign capital.
If global investors lose confidence in Britain then a “balance of payments crisis” and sharp sterling devaluation cannot be ruled out, says Shreyas Gopal of Deutsche Bank. “We estimate trade-weighted sterling would need to fall by a further 15% to bring the UK’s deficit back to its ten-year average.” Such a scenario is not unprecedented: the UK had to turn to the International Monetary Fund for an emergency loan in 1976 following “aggressive” spending, a nasty energy shock and a decline slide in the pound.
Goldman Sachs analysts recently warned that UK inflation “could soar above 22% next year”, says Liam Halligan in The Daily Telegraph. Price pressures herald an autumn of “widespread industrial action and even civic unrest”. Britain’s sliding pound risks becoming “a symbol of economic weakness and a broader lack of governance”.
The bond bear market will get worse
Ten-year UK gilt yields hit 3% on Monday for the first time since 2014. Rising yields are a reminder that there are limits to government borrowing, says The Times. With “the ratio of public debt to GDP…close to 100%, policymakers need to be wary”. For all Liz Truss’s talk of faster growth, “there is ultimately no route to national wealth by inflationary public financing and currency depreciation”.
Bond yields move inversely to prices, so it has been a miserable year for fixed income. The Bloomberg Global Aggregate Total Return index, which tracks global investment-grade government and corporate debt, has lost more than 20% since peaking last year. A decline of that magnitude marks a bear market. This is the first time the index has entered a bear market since its inception in 1990. Bear markets are “virtually unknown in bonds”, says David Randall on Reuters. Between 1990 and its January 2021 peak, the global bonds index “delivered an aggregate total return of nearly 470%”.
This year has thus proved a rude awakening, says Steve Goldstein for MarketWatch. This is likely to be “the worst year for US fixed income since at least 1928”. Bonds are widely considered to have been in a “secular” bull market since the mid-1980s, say Garfield Clinton Reynolds and Finbarr Flynn on Bloomberg. Yet soaring inflation and tighter monetary policy may have finally slain the bond bull. Bonds in Europe have led the sell-off, with a Bloomberg index that tracks investment-grade sterling bonds also falling into a bear market last week.
There could be more pain to come, says Jack Denton in Barron’s. “If there is a recession but inflation persists, forcing the Fed to keep turning the screws on financial conditions, the bond bear market might only get hairier.”
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