Over the weekend, as a sort of addendum to “Chaos Will Return To UK Assets,” I spelled out the UK’s “checkmate” scenario and offered one small suggestion for how Liz Truss and Kwasi Kwarteng might go about placating the bond vigilantes.
“Traders should call [the BoE’s] bluff on October 17 and keep the pressure up until either the LDI schemes crack, Truss folds or the BoE has to commit to open-ended QE in perpetuity,” I wrote, referencing the end date for the bank’s purportedly “temporary” long-dated gilt purchases. If the BoE restarts real QE, then traders could go after sterling on policy divergence concerns.
I went on to note that the UK has two weeks to figure out how to prevent another run. The BoE backstop ends on October 14. Or at least that was the plan. A good start, I suggested, “would be canceling a few of those tax cuts as a concession to the vigilantes.”
On Monday, Truss canceled one of the tax cuts. “We get it, and we have listened,” Kwarteng said. “It is clear that the 45p tax rate has become a distraction from our overriding mission,” he added. “We are not proceeding with the abolition of the rate.”
As a reminder, abolishing the 45% “additional rate” on income above £150,000 was poised to hand a tax cut to some 660,000 individuals, a decision the Treasury justified by noting that the 45% rate is “higher than the top national rate of income tax for G7 countries,” including the US and Italy. It’s also “higher than social democracies like Norway,” the government dryly remarked during the botched rollout on September 23, before lamenting that despite a 2013 cut to the additional rate, the top 1% of UK taxpayers still ended up with a higher relative tax burden a decade later. Some might suggest that’s not necessarily a bad thing, but the Truss government plainly thought it was intolerable.
Monday’s decision was a step in the right direction, but it’s probably too little, too late. Or at least for markets. Kwarteng spent last week defending the growth plan even as sterling and bonds collapsed, and Truss, a deer in headlights, remained totally mute as the pound crashed and gilts imploded. She finally broke a deafening silence on September 29, the day after the UK pension system was pushed to the brink by an acute liquidity shock, forcing the BoE to intervene. In that context, Monday’s halfhearted U-Turn was as embarrassing as it was insufficient.
The pound initially rallied, then gave it back. The consensus in markets is that Kwarteng’s credibility deficit is too large to overcome. Rachel Reeves, Labour’s Shadow Chancellor, called the scrapping of the high-income tax cut “just some distraction.” “The Tories need to reverse their whole discredited trickle-down strategy,” she said.
During a series of interviews Monday, Kwarteng tried to deflect blame for the rout in gilts. “High interest rates have been driven by the Fed all year,” he said. “There’s a strong dollar and also other banks are putting up interest rates to follow.”
All of that’s true, and it’s doubtlessly the case that the juxtaposition between the BoE’s plans to trim its gilt holdings and the Truss government’s plans to borrow to fund the growth package was part and parcel of the existential bond selloff. In other words, were the BoE still buying bonds or, at the least, had they not reaffirmed plans to proceed with active gilt sales 24 hours prior to Kwarteng’s mini-budget, the situation might not have unfolded the way it did.
But none of that changes the fact that the largest moves in yields occurred during and after the budget unveil. The figure (below) shows five-year UK yields. The towering red column on the right represents the two-day spike on September 23 and 26.
Over the ensuing two sessions, long-end yields rose inexorably. By last Wednesday, there were reportedly no buyers for long-dated gilts. None at all. And, so, the BoE stepped in. My contention continues to be that Andrew Bailey won’t be able to step away absent a total abandonment of Truss’s growth package, which isn’t forthcoming.
For their part, analysts remain generally pessimistic. “Against the backdrop of already-weak growth, high inflation and ballooning twin deficits, we had identified an inflation-vigilant BoE response to be key for GBP stability,” JPMorgan said. “The preferred BoE approach to buy time should be viewed as a temporary holding pattern for GBP rather than resolution until more clarity on fiscal and monetary policy is attained,” the bank added, cautioning that “bearish motivations for GBP remain intact, and tighter financial conditions are intensifying headwinds to regional growth from energy.” Although the range of outcomes is wide, JPMorgan views the risks to sterling as “asymmetric from policy choices.”
Goldman, meanwhile, called the policy backdrop in the UK “a mess.” “I don’t think a U-turn on the 45% tax plan saves the government from an ongoing high level of criticism,” Rabobank’s Jane Foley remarked, warning that the pound is on “borrowed” time.
Ultimately, Monday’s decision to abandon the tax break for high earners isn’t nearly enough to placate markets. If anything, it dealt further reputational damage to Truss and Kwarteng, who quite plainly don’t “get it,” otherwise they’d admit that the entire plan was haphazard and ill-conceived under the circumstances, even if it could be defended in a more benign macro regime.
Rabobank’s Foley summed it up well: “Market trust is gone.”
Truss had to take some reasonable action before there was any chance for the Fed to help the BOE. Was it enough? “Monday’s decision was a step in the right direction, but it’s probably too little, too late. ” These observations are all obvious, including my previous comments.
Given Kwarteng’s background as a libertarian, he seems oblivious to “free markets”.
I am shocked that only 660,000 people in Britain make over BRP150,000 per year. That’s the UK’s 1%. We have kids making that much. I must be completely out of touch to fail to realize that.
In fairness, 150,000 GBP used to be worth a lot more…