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One thing’s for sure: we’re all going to die.
The pound is down, gilt yields are up, some people are unhappy. Liz Truss is claiming to have been defamed over characterisations of her economic policy handling. The world’s richest man is possibly trying to overthrow the UK government, in what is possibly an escalation of the (current) Liverpool vs Arsenal PL title race into global geopolitics.*
In such conditions, a consistently reliable source of sometimes reliable information is the sellside, whose analysts are renowned for their unerring ability to analyse.
Toby Nangle is writing more cerebrally about bonds, so for now let’s focus on the Ps.
“There is good news and bad news,” writes Deutsche Bank forex supremo George Saravelos:
The good news is that the 2022 crisis was self-inflicted. It was a UK-driven policy shock. The easiest way to see this is that gilt moves back then completely decoupled from other markets and idiosyncratically sold off. This time round, all gilts are doing is mirroring US treasuries. The most straightforward way to demonstrate this is that the 10-year UST – Gilt spread is moving sideways and is exactly where it was six months ago.
So what is the bad news? It is that precisely because recent market volatility is not self-inflicted there is no easy way out. The fundamental problem the UK has is neither one of high debt nor low growth. There are many DM countries that have similar macro trajectories to the UK. If low growth and high debt was an issue, why aren’t Italy, Japan and indeed even France (OAT yields are lower than this time last year) facing such large bond market pressure? The answer is the UK’s external deficit.
We have argued over the years that it is current accounts, not fiscal accounts, that determine fiscal risks in DM. This can be easily seen in the fact that current account deficits have a better fit to the level of yields than any fiscal metric (chart 1). The more a country relies on foreign financing for its domestic debt issuance, the more exposed it is to the global environment. From the perspective of external flows, the UK is one of the most vulnerable in the G10: it has a big current account deficit and capital flow deficit (chart 2). By extension, the marginal price setter of the value of gilts is not domestic policy but global yields (ie US Treasuries). When US Treasuries sell off, gilts should sell off more than other bond markets.
Given this predicament, how does the UK get out of a vicious circle of higher yields, lesser fiscal space and lower growth. In a world of floating exchange rates the answer is simple: a weaker currency. A weaker pound does three things. First, it helps improve the country’s negative net international investment position by a mechanical revaluation of UK-owned foreign assets. Two, it cheapens up UK assets (= gilts) so eventually they become attractive to buy again for a foreigner. Third, it helps the current account deficit adjust, reducing the reliance on foreign funding.
The outcome: things will basically but OK, but you’re probably in for a bad year if your mood relates directly to the present level of cable:
When global uncertainty (and especially US Treasury yields) go up, as is currently happening ahead of the incoming Trump administration, a small open economy with large foreign financing needs naturally becomes more vulnerable. The sterling long built up over the last twelve months is now in the process of being unwound and likely has further to run. But rather than a vicious negative spiral or a crisis, sterling weakness should be considered a natural equilibrating process that cheapens up gilts so they become attractive again for foreigners to buy.
So what happens now? Jordan “Mr Brexit” Rochester and Evelyne Gomez-Liechti of Mizuho see three potential short-term stoppers:
1. Luck from abroad: Unfortunately the spark to the fire has come from near term CPI expectations and stronger US data surprises leading a Global fixed income sell-off. A weak NFP might be a relief valve in the short term, but we’d need to see Trump’s tariff/tax plans watered down. Nat Gas is already cooling off but a Russia-Ukraine ceasefire agreement with a resumption of gas flows (at least the 5% of EU imports that ended only last week) could really change the European energy outlook.
2. A more dovish BOE given slower growth and higher rates = lower CPI forecasts on the 2yr horizon (despite high near-term CPI). The other option would be for the BOE to perhaps consider slowing QT (most of which is passive already, but amounts to £100bn of roll-off per year). I don’t think we have a LDI crisis like 2022 to validate a special QE operation just yet. Recall that the BoE announced in summer the development of a contingent repo facility (CNRF) to backstop the gilt market, which suggests that the BoE is looking to offset any Gilt market related stress via repo markets. This increases the bar to touch the QT/QE part of their mandate.
3. Chancellor tightens her spending plans in a way it’s difficult to see for a Labour politician to do…
As that ominous closing “…” suggests, there will be probably practical consequences. As MUFG’s Lee Hardman puts it: “the rising cost of UK government borrowing if sustained will put pressure on the government to tighten fiscal policy.” He reckons…
Overall, the unfavourable market developments have increased downside risks for the pound at the start of this year and increase the likelihood of cable falling back below 1.2000
…which is bad, but a long way from Truss bad. Here’s SocGen’s chief FX strategist Kit Juckes, who can expect a letter from Truss’s lawyers:
In 2022 a new PM, with her new Chancellor, came up with a bafflingly ill-considered set of Budget proposals and triggered a crisis of confidence. Even then, the September 2022 fall in GBP/USD from 1.16 to 1.05 was fully reversed by the end of October and so was the spike in gilt yields.
What has happened this time, is that the increase in employers’ national insurance contributions announced at the Budget appears to have put the brakes on growth to a greater extent than (I, for one) expected. Deteriorating public finances may force unhelpful fiscal tightening sooner than expected. A global bond sell-off doesn’t help and gilts having a worse time than others support the idea that the pool of investors who will step in to ‘buy the dip’ in gilts isn’t what it was pre-Brexit. Especially in thin post-New Year markets.
EUR/GBP is likely to get over this period of excitement but it would be no surprise if some FX traders swapped EUR/USD shorts for GBP/USD ones on any GBP bounce here, because there is no longer a compelling reason to hope for significant GBP out-performance against the EUR. GBP/USD is likely to remain weak because the dominant market force – US economic exceptionalism and a widening rate/yield gap between the US and Europe/Asia – is showing no signs at all of abating.
ING’s a bit more upbeat on the foreseeable endpoint for the pound:
In a way, today’s sterling sell-off can be seen as a mini-capitulation of the overriding theme of a Trump-inspired strong dollar in 2025.
Where to from here? As above, we do not view this as the start of a chapter of independent sterling weakness and retain our forecasts that EUR/GBP will not stray too far from the 0.82/83 region this year. 0.8450/8500 could be the extent of the current EUR/GBP correction should market positioning have further to unwind. We are bullish on the dollar this year and have 1.24 as an end-year GBP/USD forecast. At this point, however, GBP/USD downside does look vulnerable to positioning and the incoming Trump agenda. 1.2250 is very possible, but 1.20 looks a bit of a stretch.
As we are obliged to mention every time we’re obliged to write about the UK economy, Britain is straitjacketed by a particular silly set of fiscal rules that have the practical effect of reifying global market moves into your local hospital getting turned into an elaborate portacabin maze.
And creative thinking appears to still be a long way off. From MainFT’s explainer on the gilt sell-off (our emphasis):
“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,” the Treasury said on Wednesday. “Only the OBR’s forecast can accurately predict how much headroom the government has — anything else is pure speculation.”
That’s right, the only people who can accurately predict the economy are this lot. Sorry, we don’t make the fiscal rules.
*Who/what is the Nottingham Forest of geopolitics?
