London:
Recent changes in the UK’s leadership position have had a positive effect on yields on the British pound and on long-term government bonds. But the reaction of the financial markets has been muted compared to the financial turmoil blamed in recent weeks on former Prime Minister Liz Truss and ex-Chancellor Kwasi Kwarteng.
After the mini-budget on September 23, the markets reacted to a bad policy: Truss’ strategy of enacting massive tax cuts without offering much certainty about how it would be financed. The turnaround caused bond yields to fall from recent highs (essentially lowering government borrowing costs) and the pound to appreciate. But in general, the market losses after the mini-budget have barely been made up.
For investors, a healthy and stable economic policy is much more important than the person who lives in number 10. And that’s why, even with a new Prime Minister, recent market moves indicate that investors continue to see bigger problems with the UK economy, both immediately and over the longer term.
In the short term, UK government bond yields have skyrocketed after the mini-budget, pushing up government borrowing costs. The lack of an accompanying forecast from the Office of Budgetary Responsibility (OBR) exacerbated this negative reaction.
Before that, the Bank of England had considered selling bonds to try to bring rising inflation back to its target of 2% by reducing the supply of money in circulation (known as quantitative tightening).
Instead, it had to change course quickly after the mini-budget. It not only postponed this tightening but also resumed quantitative easing and bond purchases, promising to buy up to £10bn worth of gilts a day to tackle a related crisis in pension funds.
Two things will now determine the future dynamics of government bond yields and dictate government borrowing costs.
First, clarity on how long the Bank of England plans to continue its quantitative easing policy (buying bonds to keep interest rates low) before reverting to quantitative easing. The markets are closely monitoring these actions and any suggestion that this support is being discontinued by the Bank could make traders and investors nervous.
Second, the government’s medium-term fiscal plan, currently slated for October 31, will also impact bond yields. Unlike the mini-budget, this plan will be accompanied by an in-depth review of the OBR, giving markets more information. In addition, the current Chancellor, Jeremy Hunt, has put forward a number of measures in the budget plan to allay concerns in the market.
It is not yet clear what the plan will be. A debt reduction strategy by Hunt and the new government led by Rishi Sunak should ensure the markets of the UK’s fiscal stability, but it is still unknown whether this will happen through more taxes or less spending. Some evidence about what would be best for the economy supports raising income taxes (capital gains tax and inheritance tax) rather than cutting government spending or raising income taxes.
In the long run, the UK’s biggest problems are sluggish growth and lack of productivity. And if the new government addresses current problems by raising taxes and cutting spending – alongside higher Bank of England interest rates – there will be more economic pain.
Changing global economy Many countries are facing similar problems to the UK, which is currently contributing to the weak global economic outlook. After a prolonged period of historically ultra-low interest rates, increases – the so-called normalization of monetary policy – were expected in most countries. But a sharp rise in inflation following the Russian invasion of Ukraine and supply chain problems during a pandemic have led most central banks to tighten monetary policy even further by raising interest rates more quickly.
These interest rate hikes and central bank policy tightening strategies could create significant financial and fiscal instability. For example, the US Federal Reserve’s deleveraging from a peak of $8.97 trillion (£7.9 trillion) in April 2022 has already caused the dollar to appreciate more than 13% in the past six months. This has presented challenges for emerging market currencies, as well as major currencies – the yen, the pound sterling and the euro – all of which have depreciated significantly against the US dollar.
This has increased inflationary pressures, particularly in the Eurozone and the UK, but it also affects government bond yields and poses a challenge to economic stability in these countries. Since August, the cost of borrowing has more than doubled for many.
But to deal with rising inflation, even more central banks will want to shrink their balance sheets by selling bonds. The total size of the asset purchase programs of the four major central banks alone is about $26.7 trillion. With a weak global economy and these other financial vulnerabilities, this will be a painful exercise for the global economy.
Indeed, such tightening will further increase the cost of government borrowing, causing major problems, especially for highly indebted governments, and for those still paying off pandemic-era aid, such as the UK and the eurozone.
The UK, in particular, is also experiencing a shift in the global economic center of gravity away from its economy. In less than two decades, the UK has shrunk in relative terms from an economy larger than China to about nine times smaller. And the pound no longer has the same status as the US dollar, meaning the financial markets will punish it severely if it moves out of line.
This means the new UK government faces a daunting task to rekindle investor confidence in the world’s economic stability, even with a new prime minister widely regarded as a steady hand.
(Except for the headline, this story has not been edited by DailyExpertNews staff and has been published from a syndicated feed.)