I doubt I was alone Monday in scouring the thesaurus for adjectives sufficient to convey the gravity of the crisis suddenly engulfing the UK.
The pound dove to a record to start the week, and at the lows was down some 8% in just two days. Gilts plunged across the curve. It was a total meltdown for the second straight session.
Sky News said the Bank of England was expected to make a statement. And they should. There was some risk, though, that if they failed to convey enough in the way of conviction to support the currency, the selling could resume.
Meanwhile, analysts and market participants were making statements of their own, most of which were alarmed, many of which recalled crises past and a lot of which suggested there’s a growing sense that the dollar’s run higher is no longer tenable. There was also a hint of despondency.
“The UK has a worse growth/inflation trade-off than most of its competitors, and a policy mix of fiscal profligacy and tight money that’s hurting confidence and encouraging dollar bulls to use sterling as the short side of a dollar long,” SocGen’s Kit Juckes wrote. “I can’t remember the last time Far Eastern investors were so keen on discussing the UK economy and assets.”
On Friday, Goldman revised its GBP forecasts to account for “the large fiscal spend and question marks around the size and urgency of the monetary response.” The pound’s Monday decline took out Goldman’s new GBPUSD three-month forecast less than 24 business hours after it was published (figure below).
“Considering the size and breadth of the fiscal package, even a 75bps hike seems likely to leave the BoE behind the curve on taming inflation,” analysts led by Kamakshya Trivedi wrote, in an FX weekly called “Not Very Sterling.”
Goldman drew a parallel with the US in the early 80s, when the Reagan administration’s tax cuts “further encouraged already-high inflation, though with two important differences that led USD to appreciate instead.” “First, the dollar benefits from global reserve currency status, and second, the Fed under Chairman Volcker was extremely focused on bringing inflation down using the Fed’s policy tools,” Trivedi said, adding that “even with these benefits, the Reagan administration’s 1981 tax cuts were quickly reversed in 1982, as they proved unsustainable.”
Trivedi suggested the pound could bottom in three months, but cautioned that “if policy does not eventually change tack, we would expect sterling underperformance to persist for longer.”
Commenting on the juxtaposition between the new issuance necessary to fund Liz Truss’s growth plan and the BoE’s QT program, UBS’s Anna Titareva noted that “gross sales to market including the BoE’s active QT sales would be the highest in the past decade at ~£212 billion and potentially 1.7 times higher next fiscal year at ~£355 billion.” The figures (below) make the point.
“To further underscore the scale of the challenge facing gilts, the total amount of gilt issuance the private market would have to absorb over the next 18 months is almost the same as over the previous 54 months,” Titareva added.
“Stay short gilts cross-market as the UK fiscal expansion increases medium-term inflation and issuance,” Goldman’s rates team, led by Praveen Korapaty, said. The bank called the selloff in the five-year sector “historic.” And that was before Monday’s additional 50bps cheapening.
ING’s Chris Turner called the pound’s drop a “crisis.” “Sterling has fallen close to 10% on a trade-weighted basis in a little under two months,” he wrote Monday. “That’s a lot for a major reserve currency, and traded volatility levels for the pound are those you would expect during an emerging market currency crisis.”
Turner and colleague James Smith outlined the options the UK has to stabilize the situation. They include a suspension of the BoE’s QT plans. “We’ve been highlighting the deterioration in gilt trading conditions all year [and] the BoE has added fuel to the fire by seeking to reduce its gilt holdings,” Turner remarked. “In an environment where private investors are justifiably nervous about greater gilt issuance, and also greater gilt riskiness, the BoE is adding to gilt supply, and will soon engage in outright sales.” Delaying the onset of QT is “low-hanging fruit,” in ING’s view.
The bank also said an emergency rate hike might help with sterling’s “collapse,” but warned that FX intervention probably wouldn’t work given the UK “only has net FX reserves of $80 billion, less than two months’ worth of import cover.” Turner and Smith reminded market participants that “no intervention is better than failed intervention.”
They called capital controls “highly unlikely” given they’d be “anathema” to Truss’s pretensions to a Thatcher-esque agenda. They also brought up an IMF credit line: “Given many references to Friday’s UK budget being the most generous since the Barber budget of the early 1970s, there will, unfortunately, be comparisons drawn to the UK seeking an IMF bailout in 1976.”
“In keeping with Friday’s theme, much of the chatter remains focused on the UK and the fact that 10-year gilt yields are 65bps higher versus Friday’s opening level, demonstrat[ing] the fallout from the current global central banking backdrop, domestic fiscal situation in Britain and implications from the strength of the dollar,” BMO’s Ben Jeffery and Ian Lyngen said. “Another benchmark currency looks increasingly poised for parity.”
Nomura’s Charlie McElligott called it a “calamity.” “Collapsing currencies create a doom loop of hastened / escalated central bank rate hike projections, with governments pursuing looser fiscal policy to offset the (negative) energy- and growth- shocks,” he remarked.
“The divergence between the gilt/Treasury spread and GBPUSD is even more dramatic now than it was in March 2020,” SocGen’s Juckes wrote, in the same Monday note cited above. “That time, the Fed came to the rescue, but I’m not holding out any hope of easier Fed policy, and not much of any coordinated policy move to stop the dollar’s rise either.”
“At this stage, we think UK authorities will probably just have to let sterling find its right level,” ING went on to say. “The UK has a reserve currency so it can always issue debt — it’s just a question of the right price.”
I’d suggest no one will be particularly excited about funding the UK electricity bill at negative real rates.
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Seems crazy for the new government to be so extreme. What is the sense in their actions? They’re undermining their own credibility. The new UK leadership is already hastening the day when they’ll be pushed out.
… a HUGE gamble, to say the least.
I just purchased a $20 bottle of sherry and a $35 bottle of bourbon (total wine prices) on Amazon uk for $35 for my parents in the UK.
When I was a kid and ERII was just coronated, a pound sterling cost $5. Now closing in on parity. Amazing! Only 2 months trade cover in FX reserves. Also amazing.
In all the fuss surrounding the UK’s current crisis I have seen no one attempt to relate their current problems to the mistake called Brexit. Maybe there’s no relationship between this decision and the country’s current troubles, but I find that hard to imagine.
Contagion? Liz Truss just made bond vigilantes globally fashionable again, by plopping them down at center court Wimbledon and letting them look like a 20-year old Roger Federer playing against, well, Liz Truss. At last count there are over 130 countries in the world with inflation rates at 6% or more, 120-ish over 7%. CB policy in this environment is like keeping up with the Jones’s when everybody is named Jones. Globally elevated sovereign debt levels must look like so much dry kindling to folks shorting bonds at this point.
empty, hailing from Germany here.
From my perspective what you mentioned above is decidedly NOT consensus.
There is definitely not a majority (or even a relevant minority) for leaving the Eurozone or even the EU itself.
Neither in parliament nor in the general public.
Except for one party, far-right AfD (translates to “Alternative for Germany”, a reference to Angela Merkels infamous phrase that saving the Euro back then was “without alternative”), who are pariahs in parliament as no other party wants to vote with them. The current ruling coalition is firmly pro-EU as well as the biggest opposition party, conservative CDU.
Regarding the (un)willingness to work/train for work there seem to be roughly the same factors at play as in the US: a sort of “great resignation” plus the unwillingness to accept low pay/ inacceptable working conditions especially in the health care sector.
What happens when foreign governments start dumping US treasuries or is that a likely scenario?
Well, if you’re talking about selling in size to defend currencies, you’re talking about China or Japan (or the Saudis I guess, but SAMA isn’t really relevant right now I don’t think). One worry is that you sell, and then you contribute to higher US yields, which then just adds to USD strength, undermining your cause. In other words, you could inadvertently end up moving rate differentials against your own currency, and thereby scoring an “own goal,” so to speak.
China’s treasury holdings fell to $980B in May — not immaterial but the lowest since 2010, and about $300B less than Japan’s current holdings.
I seem to be missing something fundamental. If the BOE is going to be selling bonds and the government will need to issue a huge volume of bonds to fund budget deficits, shouldn’t that make interest rates rise? And higher interest rates should attract capital inflows and increase the value of the GBP. But obviously that is wrong because the GBP is collapsing. Can someone explain simply why this environment is so bad for the GBP?
That’s the problem. In developed markets, the currency isn’t supposed to fall as rates rise. That’s the stuff of EMs. That’s what’s so concerning here, and it’s a testament to a complete lack of faith in Truss and a run on the pound.
H: I would enjoy hearing your thoughts on the right wing coalition that was just elected in Italy. From what I understand it won’t be surprising if Germany follows. I have been told that there are too many in Germany who don’t want to train to be skilled labor/work and those who are currently working and contributing to the social network are upset about this.
It is hard to imagine that the Euro, let alone the EU could survive this. Greece and Spain would also most likely want to have their own currency. It never seemed like a system could survive where fiscal and monetary policy/currency were controlled by different organizations.
This is what I am hearing from my German friends- but I am not sure if it is consensus or wishful thinking.
sorry for the confusion, above comment was meant as a reply to emptynester.
Typing on my phone…