Gilts once again sold-off across the curve yesterday (Wednesday), with weakness led by the long-end; benchmark 10- and 30-year yields both climbed by over 10bp on the day, touching their highest levels since 2008 and 1998 respectively. It is setting up the UK government debt market for a potential re-run of the crisis we saw under Liz Truss.
The bond market’s worry here is two-fold. Firstly, the UK continues to deal with the issue of sticky inflation, particularly stubbornly high services prices, which in turn leaves the Bank of England toeing a much more hawkish line than most of their G10 peers.
Secondly, concern persists about the perilous fiscal backdrop, with stagnant growth, and the continuing Gilt sell-off, having all but wiped out Chancellor Reeves’ fiscal headroom, which was already incredibly slim at around £10bn.
Pound selling off too
Of more concern, though, is that the climb in Gilt yields has been accompanied by a chunky sell-off in the pound. Cable fell over 1% yesterday (Wednesday), slipping back into the low-1.23s, as spot slipped to fresh lows since last April. Derivatives, meanwhile, point to this GBP weakness continuing, with one-week GBP/USD risk reversals having fallen to their most negative since early-November, implying puts trading at the biggest premium over calls since election day.
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“This dynamic, of yields moving higher, as the respective currency falls, is a classic sign of fiscal de-anchoring taking place, and of participants losing confidence in the Government in question’s ability to exert control over the fiscal backdrop,” said Michael Brown, a research strategist with Pepperstone. “We’re not at the Truss/Kwarteng stage just yet, but things are clearly on very shaky ground indeed – short GBP remains my preference.”
UK borrowing costs are now running at their highest level in 27 years. The yield on the UK’s 30 year government bond has risen above 5.25% for the first time since 1998. This is now higher than in the aftermath of the ill-fated Truss budget in 2022. The yield has risen sharply since the Reeves budget announced in November and the UK chancellor is looking in increasing danger of breaking her own fiscal rules.
Fiscal de-anchoring: what is it?
Fiscal anchoring refers to the idea that fiscal structural reforms can enhance growth in the long term. When governments’ financing needs are reduced, interest rates can fall, which can improve financing conditions for the private sector. This can stimulate investment and free up resources for the government to reduce taxes and finance more productive spending.
De-anchoring is when short-term price shocks can change long-term expectations. This can increase the risk of deflation and add to the risk premia on credit and equity.
Some say that the recent rise in global inflation may have led to a de-anchoring of inflation expectations. This is because inflation expectations may become self-fulfilling when firms raise prices and workers demand higher wages in anticipation of higher prices in the future.
What The Armchair Trader thinks
The UK government is moving into fairly dangerous territory with its current fiscal policies and this looks like it is shaping up into Reeves’ first joust with the bond market. Given the high level of UK borrowing already and her own tax plans, the chancellor really has very little room for manoeuvre. We could be moving into very dangerous territory indeed for the gilt market in the next week or so.
