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.