Loss of confidence in UK fiscal policy: the root cause for the market volatility

by | Sep 30, 2022

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Written by Rufaro Chiriseri, Director, Head of Fixed Income for the British Isles at RBC Wealth Management

The UK government’s latest Growth Plan, which involves unfunded tax cuts and threatens long-term debt sustainability, attracted wide criticism, including from the International Monetary Fund.

30-year Gilt yields surged by 115 basis points (bps) to 5.14% after the announcement of the Growth Plan, a level not seen since June 2002. The move was initially due to concerns about the policy but was likely exacerbated by pension fund cash needs.

These funds are the largest holders of government bonds, and the rapid fall in asset prices may have caused some fund managers to sell Gilts to raise cash for collateral requirements, pushing yields even higher. In order to restore orderly market conditions, the Bank of England (BoE) started purchasing longer-maturity bonds. It announced it will do so until mid-October, giving Gilts some temporary reprieve as the 30-year Gilt yield fell back to 3.92% in the hours following the announcement.

Unfortunately, we believe the root cause of the problem—which is the loss of confidence in UK fiscal policy—will not be addressed by this intervention, and we expect increased pressure on Gilt yields in the near term. We see an increased likelihood for a jumbo rate hike of at least 100 bps at the BoE’s Nov. 3 meeting; current market pricing reflects a possible 150 bps hike.

The government’s fiscal policy also severely affected the pound, which fell to a record low of $1.04 GBPUSD before recovering to around $1.08 GBPUSD. Sterling’s weakness comes despite the move higher in interest rates, causing some market participants to draw comparisons to an emerging market currency with a growing risk premium. The pound remains vulnerable, in our view, and it’s unclear to us if monetary policy intervention by itself can stem the rout.

 

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