A week in review: how the UK market turmoil spread across the world

This week will go down as one of the most pivotal for financial markets for years, certainly for British assets. The markets patience with excessive government debt loads finally snapped, and the UK was in the firing line. Ahead of Kwasi Kwarteng’s “fiscal event” on 23rd September, the markets had been relatively sanguine about governments across the west, and particularly in Europe, jacking up their debt levels to target the cost-of-living crisis, for example the UK’s energy price guarantee. These short-term boosts to public spending were accepted, and in some cases welcomed, as ways to protect the economy from volatile energy markets impacted by the war in Ukraine. In the UK, the estimated cost of the energy price guarantee is £150bn, however, the Chancellor’s tax cuts are “only” expected to cost £45bn, yet that was the straw that broke the camel’s back and caused major stress in the FX and bond markets and a near financial crisis for the UK pensions industry. Below we will look at what this means for markets generally, and what is driving the volatility in the price action, which other countries are at risk as well as a roundup of the macro data that was released this week.

Why the UK was targeted by animal spirits

What is interesting is that the £45bn of tax cuts that were announced last week had been well flagged to media ahead of the event, so why the sharp and adverse reaction in the FX and bond markets? We believe that the market’s reaction was down to two factors: 1, the long-term impact of the tax cuts and the failure to raise enough in taxes to cover your costs is the biggest problem. 2, we have now entered a new era, the end of cheap money and cheap financing for governments. Thus, the UK government’s decision to embark on the biggest fiscal giveaway since the 1970’s should have been accompanied by a long-term plan that included long term deficit forecasts and a plan to bring the UK’s debt under control. Instead, we got vague plans for how to boost growth, which may or may not work, and a target rate of growth of 2.5%, which may never be reached, especially after years of economic stagnation and low productivity. The UK was targeted last week; however, it is a lesson for the Western world that markets can turn on you with massive consequences. The market reaction was huge, and a $45bn tax giveaway led to a £65bn bailout by the Bank of England.

At the end of this week, markets had calmed down. GBP/USD was trading back above £1.11, although it gave back some of its gains at the end of the day on Friday, when rating agency S&P, said that it had put the UK’s sovereign credit rating on negative watch. Likewise, the bond market had recovered somewhat, and yields had fallen back sharply, especially at the long end, where 30-year yields had fallen from above 5% to below 4%. But borrowing costs were still 50 basis points higher than they were before the Chancellor’s Budget which means higher borrowing costs for corporates and for those trying to buy a home. In fact, more than 40% of mortgage products in the UK are still off the market, which will likely lead to a slowdown in the housing market at some stage.

The Conservative Party Conference: Kwasi better keep quiet

Thus, PM Truss’s plans to boost growth with her orthodoxy-defying Budget has no chance of success if the financial markets don’t play ball and if the banks don’t reintroduce their mortgage products. It has been said that a political party that attacks an Englishman’s castle and their pension is toast at the next election, and Truss’s miscalculation with this Budget is also having a big impact on the Tory Party’s electability, with their popularity plunging according to the latest polls. The Chancellor is already facing calls to resign and for an enquiry into his attendance of a champagne reception held by UK hedge fund managers in the hours after he announced his Budget. Considering some of the largest UK hedge funds made billions last week by shorting the pound, it looks like Kwarteng’s tenure as Chancellor could be short lived. Recent events certainly call into question the current PM’s fitness to rule. It is worth watching the Conservative Party Conference this week and Kwarteng’s speech on Monday afternoon to see if he will torpedo the pound and Gilts for a second time. We think that the Chancellor’s speech will be short and exceptionally vague. While he can’t roll back on the tax cuts, we don’t think he will double down on them either. We think that he will instead focus on how the Tory party will play by the rules of economic orthodoxy from now on and he will also focus on his plans to bring UK debt back under control. Afterall, he can’t rely on another bailout by the BOE, and since the BOE’s temporary purchase of bonds will come to an end on 14th October, he should be wary of his words triggering excess volatility in UK markets.

Global bond market volatility in the wake of UK market meltdown

GB assets may have calmed down, but we think the market remains jittery and ready to press the sell button if the government slips up yet again. While the UK is front and centre in our minds, other events that could impact markets. Also worth noting is that the tumult in UK bond markets also spread to US and European bond markets. For example, the 10-year Treasury yield rose by the most since March 2020 after the BOE’s announcement that it would support the UK gilt market. German bund yields also rallied on the news. While some of the moves are due to technical factors – some funds will trade bonds in all regions – it also highlights the shared challenges faced by the Western government’s that need to fund energy packages and public services with debt in an environment where interest rates are rising sharply due to inflation. The problem of inflation is also growing on the Continent, where Eurozone inflation soared to a record 10% last month, which is piling pressure on the ECB. Energy prices in the currency bloc are up more than 40% in a year, along with double digit increases for food prices and tobacco. Core inflation is also rising, suggesting that inflation is becoming embedded in the Eurozone economy, which is heaping pressure on the ECB to hike rates by at least 75bps at its October meeting. The ECB is in an unenviable position: it must try and rein in inflation, which is caused mostly by supply side factors and is thus out of its control, and it has to raise interest rates at the same time as the Eurozone economy is looking frail. This supports a weaker euro, higher bond yields and ultimately weaker stocks.

Weaker stock markets to continue into Q4

A final point on stocks, US stocks recorded their third consecutive quarter of losses, after falling 5.3% between June and September. This is the longest losing streak since the financial crisis. The selloff may continue, as a pivot from the Fed seems unlikely, after FOMC member Lael Brainard said last week that the Fed is watching financial markets but is still committed to hiking rates. Thus, as we wait for Q3 earnings season, at this stage we can’t see an end to the stronger dollar/ weaker stocks theme that has persisted for most of this year.

Chart 1: UK 30-year yields