Sunday, September 04, 2022
Slump in sterling and gilts reveals markets' fears for the UK
Posted by David Smith at 09:00 AM
Category: David Smith's other articles

My regular column is available to subscribers on This is an excerpt. Not to be reproduced without permission

We’ve all done it, and you might describe it as one of those very British problems. You are talking, in hushed tones, and not necessarily unkindly, about somebody in the corner of the room who is hard of hearing. Then suddenly, in an unexpectedly loud voice, they say: “I can hear you; you know.”

I have been thinking about this over the past few weeks, when the Tory leadership candidates, and in particular the frontrunner Liz Truss, have been pitching to the party’s membership about what they want to do to the Bank of England and the Treasury, alongside plans for unfunded tax cuts and spending commitments. For Truss, economic policy appears to consist of telling the Tory membership what it wants to hear.

But there is another audience, which reads the papers, watches TV and listen to the radio, the financial markets. And they, though not the target for the pitch, are saying: “We can hear you; you know.”

It reminds me a bit of some of the episodes of the past few years, when cunning plans to catch the EU out with the latest Brexit negotiating wheeze are briefed to the papers here, on the assumption that Johnny Foreigner in Brussels is incapable of reading them.

August was a cruel month for the pound, its worst for six years against the dollar and pretty ropey against a basket of currencies. Six years ago, of course, it plunged on the referendum result. In the middle of the week there was a neat symmetry about sterling’s exchange rate against both the dollar and euro. Both were at 1.16; $1.16 and €1.16, both massively below what used to be their long-run averages.

People notice the weak pound, directly when they travel and indirectly via higher prices for imports. They may not notice something which is as important, the performance of UK government bonds, gilts. August was also the worst month for a long time for them, with the biggest sell-off since 1994. A sell-off in gilts means a rise in the yield, or interest rate, on them, which in time feeds through to an increase in the cost of government borrowing.

During August, the yield on two-year gilts rose above 3 per cent for the first time since the financial crisis, while 10-year gilt yields rose to their highest for eight years.

Not all of this can be put down to Truss’s economic policy musings on the campaign trail, but judging from some of the market commentary I have been looking at, quite a lot of it can.

Bill Blain, a market veteran who is strategist for Shard Capital, has a big following with his “Morning Porridge” daily notes. One follower is the former chancellor Sajid Javid, curiously a Truss supporter. In fact, I met him at a small breakfast hosted by Javid at 11 Downing Street, two chancellors ago.

A couple of days ago, Blain issued a stark warning. “The UK is at risk of breaking its ‘virtuous sovereign trinity’ of stable politics, currency and bond markets,” he wrote. “Collapsing confidence in politics to stem the slide in sterling and thus gilts, could see the UK stumble into a sovereign financial crisis sooner than we think possible.”
You will remember, after the financial crisis, the then chancellor George Osborne was determined to keep the markets onside and the UK’s sovereign debt ratings intact, to avoid a sell-off in gilts.

Lord Macpherson, Treasury permanent secretary at the time, observed the other day that the combination of a falling pound and rising gilt yields is his former department’s “worst nightmare”. Truss wants to shake-up the Treasury, the Bank and launch her first package of economic measures without an accompanying assessment from the government’s economic and fiscal watchdog, the Office for Budget Responsibility (OBR). The risk is that we are entering a period in which crisis management will be the norm.

Recession fears are growing, with both Goldman Sachs and the British Chambers of Commerce adding their names in recent days to organisations predicting it. Goldman says a further energy price cap in January could push inflation above 22 per cent, which really would feel like a return to the 1970s.

According to Blain, who admits to both voting for Brexit, and for the Tories in 2019, and whose commentary overlays a photo of Truss: “The UK has long prided itself on stable politics. That appears to be breaking down – and it changes global perspectives on UK investment opportunities.”

And, he added: “Sound government by grown-ups would stand a good chance of creating the stability and confidence the UK needs to borrow its way out of the looming crisis. Picking a jury that hasn’t already decided Liz Truss will just be No 4 in line of Tory failures will be a problem. The UK needs a clean start.”

Another commentary that caught my eye was from Steven Bell, chief economist and a director at the fund manager Columbia Threadneedle. In his note to clients, he asks the question: “Will sterling hit parity with the dollar?” I have known him for decades, including at the time when the pound almost did drop to equal just one dollar, in early 1985.

Back then, sterling was regarded as a “petrocurrency” because the North Sea was churning out vast quantities of oil and gas, on a scale that would be rather useful now. The pound fell to just $1.04, in spite of a 4.5 point rise in official interest rates in the space of a month.

Bell now describes what he says is “a deeply worrying background for the UK and sterling in particular”. “If, as widely expected, Liz Truss is the next Prime Minister and responds to the cost-of-living crisis with untargeted tax cuts, the result will be an even wider deficit, higher inflation and perhaps even a political crisis as millions of households struggle to pay their energy bills,” he writes. “Tinkering with the Bank of England’s remit would also worry financial markets.”

The other backdrop is the UK’s large deficit on the current account of the balance of payments, which on an underlying basis reached 7.1 per cent of gross domestic product (GDP) in the first quarter of the year. Mark Carney, the former Bank of England governor, once warned that because of such deficits, the UK was dependent on “the kindness of strangers”. Now the strangers are getting restive and have been selling gilts and the pound.

As Bell puts it: “The UK is running a big current account deficit and the red ink has been flowing for decades. Deficits of this size are difficult to sustain and make currency weakness a real possibility.” He warns that the pound could test its all-time lows against the dollar.

It is not a pretty picture. Of course the new prime minister, assuming as everybody does that it is Truss, could surprise us, and reality replace the froth and nonsense of the leadership campaign. But there is a lot of ground to be made up, and first impressions count, including of a cabinet which, if the advance briefing is to be believed, even its best friends would not describe as being made up on all the talents.

The vultures are circling. The markets have been listening, and they do not like what they have been hearing.