Market alarm tests Kwarteng’s will

Investors are alarmed at the extent and speed of the UK markets’ decline after Kwasi Kwarteng announced his growth plans. But when the chancellor himself is unnerved, he hides it well.

Speaking in Parliament on Friday morning to outline his plans, which include larger-than-expected tax cuts and more than $60 billion in additional debt sales this fiscal year.

Over the course of Friday, the pound fell below $1.09 against the dollar – a drop of more than 3 percent in just one day! And it’s also seen a 2 percent decline against the euro, showing that it’s not all about a rushing dollar.

We haven’t seen anything like it outside of Covid-19, the financial crisis or the crash after the UK voted to leave the EU. At the end of the day, analysts at Deutsche Bank called for an emergency rate hike as a “circuit breaker” for the system.

The bond markets were in turmoil. A fall in gilt prices pushed the 10-year bond yield up about 0.33 percentage point to 3.83 percent, meaning yields rose 0.7 percentage point over the week – a massive move by the standards of a market that has historically bumped around tiny steps.

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“It’s fair to say that the government bond market hated today’s mini-budget,” said Jim Leaviss, chief investment officer of public fixed income at M&G Investments. Hate is a big word, but it fits pretty well. Global investors are bluntly reluctant to foot the bill for the UK government’s plans.

But when asked in the House of Commons by an opposition MP about the Bond shock and how he might plan to mitigate it, Kwarteng was strikingly confident. “Markets will react as they wish,” he said, adding that drawing attention to sterling’s recent fall was an attempt to “belittle the UK”.

Faced with another opportunity later in the day to reassure investors, Kwarteng said he did not comment on market movements. “I think it’s a very good day for Britain,” he added.

This is reminiscent of the famous blunder that Christine Lagarde committed in spring 2020. At that time, Covid bit and investors sold Italian government bonds. Everyone remembers how swings in Italian bonds can wreak havoc on the entire European debt market, so the new European Central Bank President was asked – what would she do? Her response was that she “wasn’t there to close the spreads between Italian bonds and the rest of the market.”

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The dealers obviously didn’t agree. A bad bond situation immediately turned much worse, prompting Lagarde to make a quick apology. However, this situation is different. The British government is more steadfast.

This period will be uncomfortable for ministers. Markets are fickle, of course, but the blows are used as a stick by opposition politicians to hit the chancellor and prime minister.

Fund managers don’t seem ready to back down. “The UK is in the uncomfortable position of having to cope with staggering inflation and declining or recessionary growth while its currency is being crushed,” said Craig Inches, Head of Rates and Cash at Royal London Asset Management. “We have believed for some time that gilt yields will rise and the UK will underperform its global peers. Today’s mini-budget confirms this view.”

But Kwarteng’s response suggests he knew that pullback would come from the markets. Over time, he told MPs, investors would see how his plan would boost the UK economy and “lead us to a more prosperous future”. Maybe so — it’s a long road, a massive gamble on growth, but it might work.

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For now, however, it seems safe to assume that the government will let this go, despite the risk that a fall in sterling will exacerbate the country’s inflation headaches and despite the upward pressure on borrowing costs that the collapse of domestic gilts will bring brings buyers, the state and everyone in between. Sometimes the financial markets – the ultimate instant global test of popularity – act as a helpful counterbalance to governments’ more powerful policies. This isn’t one of those times.

Sterling is at risk of a “crisis of confidence,” said Vasileios Gkionakis, an analyst at Citi. So where to next? Many believe the pound could easily end up at $1.05, a record low or even below. A hedge fund manager on Friday offered to buy me lunch if the price hits parity. His salary is in dollars, so he pays.

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