by Simon Derrick
Since July I’ve been arguing that if the new Conservative Party leader (and therefore prime minister) veered towards a more populist fiscal policy then sterling could come under increased pressure throughout the autumn and winter. More recently I argued that, despite BOE intervention in the gilts market and a substantial recovery in the pound, this was far from over.
Unfortunately, this appears to have been a reasonable assessment of the situation. So, what happens next?
The political backdrop
The Conservative Party conference last week proved to be a non-event. Indeed, the end of the Prime Minister’s speech marked the point that markets pretty well gave up on both sterling and gilts (with the news that Fitch was putting the UK on a “negative” outlook hardly helping). Moreover, it also became apparent that, while the PM’s authority has clearly been undermined, no credible challenger to her position is waiting in the wings. The government therefore limps on under its current leadership despite trailing the Labour Party in the polls by between 25 and 30 percentage points indicating electoral wipe-out, in the knowledge that a General Election must take place no later than January 2025.
Even without the current market backdrop this would represent a steady drag on sterling over time. As always, it’s important to note that this is not a reflection on the economic competence of a potential Labour or coalition administration. Alistair Darling, for example, did an exemplary job during the financial crisis. Neither is it a comment on how sterling would perform under such a government. The pound did well for many years after Labour came to power in 1997. Rather, it is simply a note on how the pound has performed in the past ahead of elections when Labour has done well in the polls.
Official response to market turmoil
Whatever Chancellor Kwasi Kwarteng’s intentions when he presented his mini budget, it’s clear he now recognises the need to rapidly regain the trust of investors beyond simply backtracking on the politically divisive 45p tax cut. Most obviously he has brought forward the date he intends to announce his broader plans, along with official forecasts, to October 31st from the previously announced November 23rd. In addition, he has announced the appointment of James Bowler (who spent two decades at the Treasury) as the department’s new permanent secretary.
Unfortunately, the market response to this news can best be described as unimpressed with sterling just managing to hold on to $1.10 and 10 year gilt yields stuck near their late September peak. This comes despite the BOE increasing the daily limit on its gilt purchases and widening the programme to include index-linked paper.
It is also worth remembering that the BOE is walking a very fine line. On the one hand, it does not wish to encourage the idea that it is monetising debt or effectively easing monetary policy at a time when it is becoming increasingly concerned about the outlook for inflation. On the other, it does not wish to put financial stability at risk. This may go some way towards explaining the slightly curious sequence of events on Tuesday and Wednesday. BOE governor Andrew Bailey comments in Washington on Tuesday appeared to be a clear warning to the pension fund industry that the bank’s support will end this Friday. While the FT reported on Wednesday that the bank had “signalled privately to bankers that it could extend its emergency bond-buying programme past this Friday’s deadline.”
Whatever the intention, it’s hard to argue these mixed messages were anything other than mildly confusing. Little wonder then that the pound spent much of Wednesday morning oscillating around $1.10.
Market conditions
Given the tepid response from investors to these developments, it’s worth considering the broader reasons why the new PM and her chancellor misread the situation so badly back in mid-September.
The most likely reason is that they were unaware that market conditions have been changing this year. One simple measure of this is to think about Sterling’s performance against the Euro, rather than the US dollar, in the first half. Up until January, sterling had been relatively stable against the Euro for around five years, the most likely explanation for this being the very modest yield pickup available in the UK. However, if this was true then an alarm bell should have been ringing about the pound’s performance during the first two quarters of this year.
Despite a cumulative 100 bp hike in the BOE’s bank rate, sterling weakened steadily through the spring and early summer, only reversing as it became clear Boris Johnson’s position as PM’s was becoming untenable. In other words, yield alone was subsiding as a driving force for the pound.
This shift away from pure yield seeking behavior has occurred in the context of a sharp acceleration in the bear market for bonds globally and a pace of Fed Funds rate increases comparable to any seen in the past 50 years. In other words, as the tide of ultra-easy money has rolled back this year investors have no longer had to scramble quite as hard for yield and consequently have focused on other issues for the first time in probably half a decade.
What they can now see, beyond the UK, is not particularly encouraging. Copper prices are down 28% from last year’s peak while Brent crude is off over 20% since June despite production cuts by OPEC+. Other commodity prices such as lumber (down over 2/3rds since March), iron ore (nearly 40% lower) and even natural gas (off over 30% from the August peak) tell a similar story of a global economy where demand appears to be slowing rapidly. It must also be said that this is surprisingly reminiscent of the late summer of 2008.
Given all this, it is easy to see why investors have preferred discretion over valour in recent weeks. When it is also remembered that since 1970both the current backdrop and the fact that since 1970 realised volatility in global equity markets has on average peaked out in October/November, it’s not hard to imagine caution remaining the watchword in the weeks ahead. If that is the case, then it likely bodes ill for both the Pound and Gilts.