Jeff: Welcome to the Flip Side. My name is Jeff Meli. I am the Head of Research at Barclays. With me is Ajay Rajadhyaksha, our Global chairman of research. Thanks for joining me Ajay.
Ajay: Good to be back here, Jeff
Jeff: Today, we are going to talk about the recent market turmoil in the United Kingdom. The yields on UK government bonds, known as Gilts, have risen sharply, and the Pound has fallen – hitting lows against the dollar that have not been seen for decades. I think you could make a case that this has been one of the most tumultuous periods ever for UK financial markets.
Ajay: Well, Jeff, if anything I think you are understating the magnitude of the volatility. The interest rate on 5 year Gilts rose half a percent on just one day, which is an unprecedented move. Then it happened again the next day! It has been four decades since the pound was this low against the dollar, and there are aftershocks on the rest of the UK – like the equity market. Their main index, the FTSE, is underperforming global equities, and in some ways is leading global financial assets lower.
Jeff: So the question is what is the source of this volatility.
Ajay: I’m sorry to say it Jeff, but I think the answer is pretty obvious. The market is reacting to a series of policy proposals announced in the new Chancellor’s mini budget. The tax cuts in particular are causing concern; investors are questioning the United Kingdom’s fiscal sustainability and the government’s credibility.
Jeff: The policy proposals are a convenient scapegoat – there’s no denying the coincident timing of the volatility with the proposals. But I think the proposals themselves and the volatility we are experiencing are really both a reaction to the very difficult underlying economic circumstances the UK, and frankly in the rest of Europe as well. They are experiencing something here that is almost unsolvable, and that something had to give. It’s not clear to me that alternative responses would be any better in the long run, or even necessarily lead to lower volatility.
Ajay: Let me start with the recent proposals. First, the UK announced a major energy cost subsidization program. Consumers’ energy bills will be capped, to try to buffer against the massive increase in energy costs that are linked to the war in Ukraine.
Jeff: Indeed. We know that here in the US, there are massive repercussions when gas prices rise – we saw some of that over the summer when gas got over $5 gallon. But that is nothing compared to the rise in energy prices in the UK. Without this subsidy, businesses and households were facing energy costs that are 4-5 times as high as they were one year ago! Natural gas prices are over six times what we pay here in the US! Higher energy costs have been a huge driver of inflation in the UK, which is now hovering near 10%.
Ajay: The key is that the subsidy will be funded with new government bond issuance – the energy costs are what they are – it’s just the government was going to pick up part of the tab. Then the new Chancellor followed these with a set of proposed tax cuts as well, that would even further raise the borrowing needs for the UK. This was a one-two punch – and turned out to be too much for markets to stomach. On the day the budget was announced, the pound started to drop and the yield on Gilts started to rise – it’s really hard to attribute this to anything else.
Jeff: Hold on. You mention the energy plan; that’s the biggest part of the cost of the total proposals, and that’s not unique to the UK. These energy costs are being felt everywhere throughout Europe and practically every European country is trying to shield their consumers from this massive rise in costs. Germany announced a new national gas price brake. We’ve seen programs announced in France, Spain, Portugal – a number of others too – everyone is trying to announce some form of support and to just to keep in mind what they’re announcing particularly in the UK is not really a long-term increase in debt – the program is intended to be paid for up front through new government borrowing, but in the long run the borrowing would be paid back through future levies on energy – I understand those details haven’t been announced yet. But really what they’re trying to do in the UK is to smooth the higher energy costs over several years, under the assumption that these prices represent the current crisis that’s happening and that crisis isn’t going to last forever, so this isn’t really like a straight up subsidy.
Ajay: In principle, yes, but didn’t Milton Friedman say that there is nothing so permanent as a temporary government program? I think bond investors should and will be skeptical about promises of future taxes or spending cuts.
Jeff: Fair enough, but regardless, buffering the costs of energy now is surely better than leaving consumers to absorb this all at once in terms of the overall economic impact on the UK?
Ajay: But that’s not all they’re doing. The fact that the energy subsidy is coupled with the tax cuts that’s the problem and as the energy crisis has worsened, the costs of that subsidy have grown and it’s the combination of the two that markets are saying the UK cannot afford.
Jeff: Ok Ajay, the other issue with laying all of this at the feet of the new mini-budget is that this set of proposals was incredibly well telegraphed. Throughout the leadership contest, the new Prime Minister, Liz Truss flagged her plans repeatedly. In fact, the only surprise in the whole set of proposals, might have been the removal of the 45% tax bracket, but as you know, that was not a significant part of the overall costs and it’s since been reversed. Remember that the day before the budget announcement, the Bank of England raised interest rates by only half a percent, but the entire market was expecting 0.75% which was in line with what the US Federal Reserve had done a few days earlier. The Bank of England didn’t move aggressively enough which maybe raised the risk that inflation would stay elevated, and would force interest rates to go higher in the future. Maybe the explanation for this volatility isn’t so clean cut after all.
Ajay: If that were the case, I would have expected a strong reaction on Wednesday evening and Thursday morning, right after the Bank of England meeting. Instead, the UK bond markets really started losing it from Friday, after they digested Thursday’s budget. I know that these events are happening in close proximity, but in the rates and FX world, markets move fast. It doesn’t take a full day for news to get digested.
Jeff: I’d also say Ajay, that this seems like an overreaction from a purely fundamental point of view. You say that markets are questioning the ability of the UK to fund all of these proposals. But the UK has the second lowest debt-GDP ratio in the G7. I don’t understand this, it seems to me it can afford this move, even unfunded. Investors will realize that debt will fall as a share of GDP in the medium term. I think markets just got swept away during a period of illiquidity, and the blame landed – unfairly – on the new government’s budget. As time passes, things will calm down and we will look back on this as a buying opportunity for UK assets rather than a big problem for UK markets.
Ajay: Jeff, even the IMF has come out and urged the British government to turn back its tax plans. They don’t usually wade into developed economies. They haven’t asked that of any other developed economy right now. The fact is: markets determine what is affordable, not analysts (no offense to you…or to me!). And the market is showing its cards. I am worried that this is just the start of a period of severe UK volatility.
Jeff: Don’t forget, Ajay, the government has plans to announce spending cuts soon that will be paired with these proposals, that could seriously help turn sentiment.
Ajay: Spending cuts are very difficult to push through in the UK right now. The government is one of the biggest employers, for example, the previous Chancellor – Chancellor Sunak - promised that benefits would rise with inflation. The government would have to walk back such commitments - a very difficult thing to do politically. Also, keep in mind that the Bank of England announced emergency measures to stabilize the market for UK government bonds – they are buying gilts! That is in a period where inflation is surging and they were planning to sell assets to try to keep inflation lower! Ultimately under the hood, this is exacerbating the economic stress the UK was already facing.
Jeff: Well Ajay, my main objection to this narrative is that this is still mainly a global issue, not a UK issue, and that the same trends are showing up everywhere. In the last year we’ve seen massive dollar strength against the euro, yen and any other currency you could mention, not just sterling. We’ve seen interest rates rise across the globe. As an example the interest rate on a 10 year German government bond has doubled – from 1.1% to 2.2% - just over the last month. The UK is not the only country where there’s been this kind of financial market volatility.
Ajay: Rates are higher everywhere, but not 1% in 2 days…not 3% in a month! That’s just the UK.
Jeff: Sure, but it is also the case the Bank of England is not the only Central Bank that’s been forced to intervene in markets. We’ve seen several other examples of intervention that’s working in ways counter to what the Central Banks would prefer to do to battle inflation.
Ajay: That is fair – we have seen interventions from the Bank of Japan to defend the yen, and the RBI intervened to defend the Rupee. And on Friday, we heard that China was defending its currency too. So yeah, that’s true.
Jeff: And the European Central Bank recently announced an anti-fragmentation tool, that’s central bank speak for a program that’s designed to stop the yields on some of the weaker European economies from rising too far. That sounds like intervention to me! Actually it’s very similar to the intervention the Bank of England just did. The fact is that the global economy is struggling with the rise in inflation in general, and with energy costs in particular. The US economy is strong enough, certainly stronger than other parts of the developed world, that in the US the Federal Reserve can raise rates aggressively and battle inflation. But because the Federal Reserve is raising interest rates, the dollar goes up in value against other currencies. That actually makes inflation worse abroad, so for example countries that have a weaker currency, things like energy and food cost more for them so that actually exacerbates inflation for them.
Ajay: This is all true, Jeff. But then additional government stimulus, in the form of a tax cut, that is what is a terrible idea. Remember, the COVID relief bill that President Biden passed is widely considered to have been a major source of the inflation being experienced in the US. Poorly timed fiscal stimulus can do more harm than good.
Jeff: I think the goal is to use the stimulus to buffer against the economic pain of higher rates. Keep in mind that the sensitivity of the UK economy to higher rates is quite elevated. For example, the mortgage market in the UK has a much higher variable component, and as interest rates go up, house payments will rise – maybe as much as 50-60%. Data came out recently that showed that UK home prices have stopped rising from July, for the first time in many years; this is likely just the beginning of the economic aftershocks of higher rates and maybe this stimulus is well timed to try and get ahead of that?
Ajay: Sounds like you are trying to have your cake and eat it too. The fact is, the rate hikes that are now needed, will be more severe in the face of these tax proposals – certainly the market believes that. In the end, I agree that the UK is in a tough spot, and that some of this spending, like the energy package is necessary. But the goal should be to spend the minimum necessary, and not to make the underlying issues worse.
Jeff: I also think much of this was a near-term market move that is maybe feeding off of itself to some extent. Remember Ajay, after all the excitement died down the pound recovered a fair bit by late last week.
Ajay: But only because the Bank of England is doing open ended intervention which it will continue to do until Oct 14th! What happens after that? Who supports the gilt market? And interest rates are still magnitudes higher than before the tax cuts were announced.
Jeff: Well, I also feel that there is a longer term issue here. The UK is of course no longer a part of the EU. It needs to attract investment, and find a way to compete as a smaller economy. Lower taxes, and less burdensome regulation – that’s another area the recent announcements has been focused on, it hasn’t generated quite the same market reaction, but the UK is taking significant steps to remove the regulatory burden, these aren’t crazy paths towards achieving a more stable, long term view for your economy. In the end, they need to give investors a reason to see the UK as an attractive place to put your money, to put in a weaker currency on top of that, all of a sudden the whole package starts to look a lot better.
Ajay: That’s a nice theory, and I’m not saying it’s wrong, it is worth debating as a long-run proposition. And I’m not complaining about the regulatory changes, I’m saying the timing on the tax proposals seems to me to be counterproductive right now, in the midst of all the global economic pressures you mentioned. I hope I am wrong Jeff. I really do. But I worry that over the next few weeks, UK-specific market volatility will return, the currency will start dropping and bond markets will keep losing value. Especially as we approach October 14th when the Bank of England’s purchase program is supposed to stop.
Jeff: I guess we will find out soon enough which side wins out. And in this case, I hope you’re wrong too Ajay! Until then, clients can read our most recent research pieces on this topic by following the hashtag #UKTurmoil available on Barclays Live.