- Macro Strategist
Denmark, Intermediary
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With the goal of cutting through all the chatter and headlines around the United Kingdom’s (UK’s) woes these days, here’s my current take on the situation and its broader global implications.
First, the Bank of England hiked…
Last week, the Bank of England’s (BoE’s) Monetary Policy Committee (MPC) increased interest rates by 50 basis points (bps) — the second consecutive hike of that size, continuing the hiking cycle started in December 2021 and bringing the policy rate up from 1.75% to 2.25%, a level not seen since 2008. That being said, the MPC is not following other global central banks — such as the US Federal Reserve (Fed), the European Central Bank (ECB), and the Swiss National Bank (SNB) — in hiking rates by 75 bps to counter stubbornly high inflation.
In effect, the MPC is running the risk of looking “soft” on inflation, particularly for a country that is experiencing acute inflation dynamics and has a long history of generating inflation. With the UK labour market at its strongest since 1973, loosening fiscal policy (see below), together with other central banks enacting larger rate hikes, should apply added pressure to tighten monetary policy more aggressively. In my view, however, the BoE isn’t showing much urgency to do so and thus risks losing credibility in its drive to tame inflation (more on that below).
…and then came the mini-budget
On 23 September, the UK government announced a significant fiscal policy package, worth ~9% of national GDP over the next 2½ years and putting in place the biggest set of UK tax cuts since 1972. With the British economy stalling, this government is actively seeking growth at a time when achieving price stability (lower inflation) requires a slowdown in demand, as exemplified by Fed Chair Jerome Powell’s remark that some “economic pain” would be necessary to conquer US inflation. Puzzlingly to me, the UK government’s fiscal actions seem to represent an extraordinary policy experiment designed to keep inflation high.
Markets circling GBP and gilts
In response, global investors have punished both British gilts — bonds issued by the UK government that are generally considered low-risk equivalents to US Treasuries — and the British pound (GBP). The initial market reaction saw gilt yields spike by over 100 bps (Figure 1), while the GBP declined by more than 6% against the US dollar (USD) over the same period.
Figure 1
These sell-offs essentially amount to the markets harshly rebuking UK policymakers, specifically: 1) a BoE seemingly lagging, and too complacent about, inflation; and 2) a new government determined to loosen fiscal policy dramatically over the next few years. That combination has engaged markets to precipitate a British currency and gilt crisis not seen for three decades, with international investors “circling” the UK, which now looks exceptionally weak due to multiple factors:
- It is sporting a very high current account deficit, around 8% of GDP, basically meaning that demand for goods and services is well above supply.
- The large fiscal package just announced has little chance of closing that deficit, pushing up demand right when a reduction is needed to bring down inflation.
- The central bank is widely perceived to be behind the eight ball with regard to monetary policy, especially given the UK’s ever-worsening inflation outlook.
So what’s next for the UK?
The backdrop for British gilts and the GBP remains quite challenging and could stay that way for the foreseeable future. On the fiscal side, what I think is needed is a coherent plan aimed at raising trend growth, rather than just short-term growth. Markets will want to see a serious attempt by the UK to restore economic stability, at the very least in the short term, in order for those British asset sell-offs to ease up.
I expected this to come from the BoE in the form of a substantial intra-meeting rate hike, engineering a recession to halt inflation and shore up the currency. Instead, we got an extraordinary development on 28 September. Two days after releasing a statement that showed little urgency to calm markets, and only five days before the planned start of its quantitative tightening programme, the BoE announced that it would “temporarily” purchase long-dated gilts. While this was ostensibly to address growing concerns around financial stability, it came on the same day the government issued 30-year bonds and yields rallied aggressively after the BoE’s actions. At this point, the central bank may not be able to reverse quantitative easing.
What about other countries and regions?
The UK may be in the eye of the storm at the moment, but it hasn’t been alone in pursuing ill-advised monetary and fiscal policies over the past decade. The UK’s efforts to raise demand amid a persistent negative supply shock echo what’s occurred in Japan and Europe, whose sovereign bonds could be the next ones targeted by investors:
- Japan: The Bank of Japan (BoJ) has been “deliberately irresponsible” (its own words) by defending negative rates in its bid to structurally raise inflation expectations — this in an environment where other global central banks have been doing the opposite and hiking rates. Last week’s currency market intervention by Japanese policymakers to prop up the yen (JPY) could be a warning sign. If markets need a reason to focus on Japan, I expect an emergency budget in a few weeks’ time. Wage growth at or above 3% could be another catalyst.
- Europe: While not in the same predicament as the UK, Europe’s current account surplus has eroded this year, while fiscal announcements have begun to pile up. If markets become uncomfortable with fiscal loosening (e.g., German price caps on electricity) or deteriorating public finances on Europe’s periphery, European rates and the euro might be vulnerable. Potential catalysts: the ECB’s Asset Purchase Programme being wound down and the ECB having to take steps to stop peripheral spreads (i.e., in Italy, Spain, and Greece) from spiraling out of control.
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