The market dynamics around the Sterling (pound), and especially visible in cable, are unusual and concerning. UK gilt yields (how much interest is paid on government debt) has risen sharply in recent days. Normally, that would imply a stronger currency. But the pound has instead sold off, falling as much as 1.5% over just two days.
The underlying issue is that investors are worried that the UK government will be able to make due on its financial obligations. This means they are demanding higher interest rates to buy British debt, pushing up yields. The lack of confidence in future economic growth has left investors also selling the Sterling (pound). That combination is particularly concerning as it was the formula that applied during the last budget crisis of 2023 which ended Liss Truss’ premiership.
A Repeat, or Something New?
Government officials and even analysts and economists are hastening to reassure that the situation isn’t the same as back in 2023. That’s despite yields going higher than they were a year and a half ago. In fact, they have risen to surpass the peak during the Great Financial Crisis and reached the highest they’ve been since 1998.
The thing is, the UK isn’t exactly an outlier, just the most affected by what appears to be a global trend. Yields in US and German debt have moved higher as well. Some analysts suggest it could be because that liquidity remains a bit light due to the recent holidays, and should normalize. There has been a significant amount of debt issuance in the first week of the year. But signs of a global lack of liquidity is concerning on its own, as it could be one of the signs preceding a recession.
How Worried Should Traders Be?
One of the difficulties of the situation is that analysts and economists are having difficulty explaining why this phenomenon is happening right now. If it was related to the budget directly, then the spike in yields would likely have occurred months ago when it was announced. If economists don’t agree on why this is happening, then they also aren’t going to agree about when (or if) it will reverse.
The uncertainty around the situation is likely to contribute to a weaker Sterling (pound) and higher yields, contributing to a vicious cycle that could keep the situation getting worse. A similar situation could happen with the Budget: Higher yields means the government has to spend more on servicing the debt. That means less room for spending, which in turn could make investors want higher yields as they are concerned about the government finances. It also poses a conundrum for the Chancellor, as it will mean either having to make painful spending cuts or breaking her promise to not raise taxes. Both of those are seen as weights on British economic growth – and it’s worries over growth that are underlying the problem in the first place.
It’s All About the Timing
In the end, it could be just a matter of how long the situation lasts. A short term (days or a couple of weeks) of high interest rates that moderate after economic data comes out reassuring the markets would likely mean a return to normal.
But, if the condition persists for a long time, it could squeeze the government’s finances as well as higher interest rates dragging on the economy. Higher rates mean higher borrowing costs, including for mortgages, which were expected to take off as the BOE shifts towards easing. But the rise in yields has all but erased the central bank’s easing moves.
Of course, one of the potential outcomes is that the BOE might be more inclined to ease at the next meeting in order to offset the impact of higher interest rates. That would likely contribute to a weaker pound as well.
What About the Data?
What could shake things up a bit is if inflation comes in outside of the range of expectations, leading the markets to shift their perception of what the BOE will do at its first meeting of the year in early February. A beat in the inflation figures would likely be seen as hampering the BOE from pushing down yields and could exacerbate the situation. A miss might act as a relief for the markets, and counterintuitively push the pound higher.
The consensus is that UK December headline inflation will tick up to 2.7% from 2.6% in November. By contrast, the core rate is expected to tick down to 3.4% from 3.5% prior.
