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When the Pound and UK gilt yields diverge, you know something is wrong.
The Pound extends losses despite the UK Treasury attempting to stabilise markets overnight by saying Chancellor Rachel Reeves would soon be setting out details to try and encourage the UK economy to grow.
An intervention by the Treasury is rare and confirms it now fears that investors are beginning to turn away from UK assets at a time when the Government will require their cash to fuel a significant increase in spending.
"No one should be under any doubt that meeting the fiscal rules is non-negotiable and the Government will have an iron grip on the public finances," said the Treasury. "Kick-starting economic growth is the number one mission of this Government as we deliver on our Plan for Change."
"Over the coming weeks and months, the Chancellor will leave no stone unturned in her determination to deliver economic growth and fight for working people," it adds.
Investors will remember that Reeves spent the months in the lead up to the July General Election promising to be pro-growth and pro-business, and then delivering the opposite on taking power.
With her credibility now severely dented, it will take concrete action, not just words, to turn the ship around for the Pound and UK bonds.
Bond Yields Up, Pound Down
The intervention by the Treasury comes as domestic and foreign investors sell the British Pound and UK government bonds over fears the country's debt and low-growth trajectory are becoming unsustainable.
The Pound to Dollar exchange rate is quoting at its lowest level since November 2023 at 1.2293. The Pound to Euro exchange rate has broken to its lowest level since November at 1.1935.
At the same time, UK government debt yields (bond/gilt yields, which rise when bonds/gilts are sold), have surged to record highs: the ten-year yield shot to 4.787% on Wednesday, its highest since 2008. The 30-year yield went up to 5.347%, the highest since 1998.
In a healthy market, the Pound would follow yields higher as foreign investors clamour for increasingly attractive returns (higher yields = greater returns for holders of UK debt).
However, the Pound has broken its positive relationship with yields, setting alarm bells ringing amongst investors; the last time it did so was when Liz Truss' 'mini budget' was rejected by markets for fears it would sink the UK's finances.
Above: Ten-year bond yields (top) and GBP/USD part ways, in a sign investors are losing confidence in UK assets.
"A worrying development in recent days is that gilt yields have risen a little more than in other markets, at a time when sterling has sharply weakened. Normally currencies are driven by interest rate differentials, where higher gilt yields relative to other countries would be expected to push the pound stronger. The combination of a weaker pound and higher relative gilt yields has eerie echoes of August-September 2022, and if this continues, could potentially be evidence of a buyer’s strike or capital flight," says Mike Riddell, Portfolio Manager, Fidelity International.
"One of the biggest red flags in macro markets - and a sign of fiscal un-anchoring - is yields up and currency down. This is happening again in the UK (the last proper time we saw this was Q4 '22... after 'that' Budget). Looks ominous," says Viraj Patel, a strategist at Vanda Research.
Growth Doom-loop
"The implication of the move is that the UK risks entering something of a fiscal death spiral. Rising yields risk compromising the macro environment, (higher mortgage rates risk compromising real estate dynamics) further undermining the Chancellor’s immediate fiscal arithmetic," says Jeremy Stretch, Chief International Strategist at CIBC (TSX:CM) Capital Markets.
Yields are, in effect, the interest rate the government pays to those it borrows money from. Surging yields means the Treasury must devote more and more of its revenues to service debt, with economists now saying Reeves has virtually no headroom left and is set to break her budget rules.
Spending more money on debt means less to go to other causes, meaning Reeves must cut spending and/or raise taxes.
If not, she will break her own fiscal rule that says debt as a share of the economy must start falling by 2029.
The rule is a critical piece of architecture that underpins credibility in the UK's finances, as well as that of Rachel Reeves and the Labour Party. Breaking them would be financially and politically ruinous.
But raising taxes poses headwinds to economic growth, potentially diminishing revenues further and creating a perpetuating doom loop for the economy.
"Rachel Reeves' ill-considered Budget is 90% of the cause as it is the exact opposite of what was required. Add to that the continual downbeat messaging from Labour and their dreadful beginning in Government, and it is no surprise things are deteriorating," says Roger Lane, CEO at Fort Advice Bureau.
"It's More Expensive for Everyone"
As soon as Labour took power, Rachel Reeves and Prime Minister Keir Starmer engaged in a messaging campaign to convey how poor the UK's finances were and that it would need to make "hard decisions". It was signalled that such decisions would involve tax hikes.
The messaging sent a chill through the economy as consumers and businesses braced for the impact of the budget, which, in October, duly delivered the pain.
Pound Sterling Live reported at the time that the budget offered "Poor Value for Pound Sterling". Markets appear to be catching up to this realisation.
Why didn't the Pound tank in October, then? At the time the economy was coming off a spurt of above-trend quarterly growth, and the Office for Budget Responsibility said the budget would actually spur growth in 2025.
Subsequent GDP growth readings have disappointed and, instead, point to an economy that is stagnating. This signals to bond buyers that the government might have severely miscalculated the effects of the budget.
This is because tax rises were mainly levied on businesses, which are the engines of the economy and the source of tax revenues. Facing significant National Insurance tax rises, inflation-busting minimum wage increases and the rollback of support schemes, business sentiment has plummeted, and hiring and investment intentions have fallen sharply.
What's more, the lion's share of the pain only comes in April when the changes are finally enacted.
"It's just got a lot more expensive for everyone to refinance their debt. If this selloff continues, it’s going to push deficits wider, which then risks a doom loop since deficits need to be funded by ever more sovereign issuance," says Mike Riddell, Portfolio Manager, Fidelity International.
The Bond Market Has a Message
Reeves thought her plans would boost growth in the economy, but the data and evidence confirm she had taken the wrong approach and achieved the opposite of what she desired.
Weakness in UK bond and currency markets confirms markets on Thursday take into consideration the Treasury's overnight intervention. The Pound's ong fear she doesn't have the cure.
"The UK is trapped in a vicious debt circle. It is almost impossible to get the deficits down. The Bank of England clearly hasn't got inflation under control, minimum wage and NI increases are being passed onto consumers in the form of higher prices," says Anita Wright, Chartered Financial Planner at Bolton James.
"The bond market is saying, we’re pretty certain a second wave of inflation is coming back, similar to the 1970s. Markets now demand higher yields to compensate for inflation risk. The Bank of England is unlikely to be able to cut interest rates in this environment and therefore mortgage rates will at best stay where they are," she adds.
Martin Weale, a former member of the Bank of England's Monetary Policy Committee, says ongoing events echo the 1976 debt crisis "nightmare" that forced the government to ask the International Monetary Fund for a bailout.
He says Labour may have to resort to austerity to reassure markets that it will address the UK’s escalating debt burden.
What does this all mean for the Pound?
We think it is clear that the economic and sentiment setup has deteriorated and the longer-term uptrend against most non-USD currencies is at risk of breaking down.
Some dip-buying activity might emerge offering short-term rallies, but we think the markets are finally catching up with the fundamentals and this bodes for more downside.
An original version of this article can be viewed at Pound Sterling Live