UK markets seem to be stuck in a vicious cycle they can’t get out of. Investors fear worsening economic conditions are down the line on the back of the latest spending plan unveiled by the government, so they get rid of domestic treasuries, pushing gilt yields higher and leading to intervention from the Bank of England to stem the volatility in the bond market. And then investors get concerned again because the BOE has had to tighten monetary conditions in response to the market reaction to the government’s spending plan, and therefore we see further volatility in gilts, and the BOE has to step in again. And so it continues.
Fundamentally, the situation hasn’t changed that much; we continue to have low unemployment and high inflation, meaning central banks will have to reduce the flow of money in the economy, but markets are now on high alert. The perception in the market is that the BOE is going to ramp up its hawkishness to deal with the fallout from the government’s tax cuts. At least that is one way to explain the market-implied peak rate in the UK being 120 basis points higher than in the US at some point in the second quarter of next year (5.9% vs. 4.7%).
Of course, these change daily in reaction to the most recent developments in the market. Still, the feeling is that the BOE is at the mercy of the markets and is going to have to go above and beyond to fix the inflation dilemma the UK is going to continue to face over the coming months.
The issue is that the latest moves from the BOE had done little to calm the market jitters, with the 30-year gilt currently yielding 4.9%, nearing the peak touched two weeks ago (5.12%) when the UK government unveiled a series of unfunded tax cuts and its highest level since July 2007. What’s worrying is that we continue to hover at these levels even after the bank stepped in once again, this time to stop the selloff of inflation-linked gilts.
But governor Bailey may have reached his limit and put his foot down, telling pension funds they have until the end of the week to rebalance their portfolios, at which point the bank’s bond-buying program will end. The reaction in the gilt market suggests investors are skeptical this will solve the issue, and with Bailey pretty much admitting systemic financial stability risks, we are likely to continue to see heightened volatility in UK assets in the near term.
Alongside UK bonds, the pound has also been getting hammered as of late. GBP/USD is an unavoidable pair to mention when talking about the pound because of the opposite situation the dollar is in. The Federal Reserve is seen to be handling the low unemployment/high inflation situation much better than the BOE, and so bond yields and the dollar are moving hand in hand with tighter financial conditions.
So GBP/USD has been left dipping below 1.10 once again, and this time the move looks more sustainable. We have lower highs and lower lows building nicely to the downside, and any attempt at a bullish reversal gets drawn out by the end of the day. The momentum remains firmly to the downside, and it’s hard to see a bullish bounce holding until the UK can regain fiscal and monetary policy credibility.
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