Sep 25, 2022

Truss Faces New Dangers as UK Markets Reopen After Turmoil

David Goodman and Libby Cherry, Bloomberg News

A logo outside the London Stock Exchange Group Plc's offices in London, UK, on Friday, Aug. 12, 2022. London Stock Exchange Plc Chief Executive Officer Julia Hoggett said the IPO pipeline in London remains robust, despite a slowdown this year that’s been felt at many exchanges globally. Photographer: Jose Sarmento Matos/Bloomberg , Bloomberg

(Bloomberg) --

The selloff in UK assets went into overdrive on Monday, sending the pound to an all-time low, slamming government bonds and sparking talk of emergency action by the Bank of England.

The market mayhem extended the damage seen on Friday in the wake of the government’s new fiscal measures, which sent investors into a panic. The plunge in UK gilts sent 10-year yields above 4% for the first time since 2010. Sterling dropped to as low as $1.0350, taking it closer to parity with the dollar, though it subsequently erased its loss, to trade as strong as $1.0931.

The tumble comes in the wake of the government’s shock tax-cutting budget late last week, which will fuel inflation and increase borrowing at a time of rapidly rising interest rates. It’s led to a market crisis that’s threatening to engulf Prime Minister Liz Truss’s days-old administration as the country grapples with a cost-of-living crisis and a recession.

It’s also prompted calls for aggressive rate hikes from the Bank of England, with some urging emergency action. Traders are wagering on about 50 basis points of rate hikes over the coming week, according to swaps ricing.

The central bank has yet to decide whether to make a statement on market conditions. It’s watching the market closely, according to someone with knowledge of the situation. Sky News reported that the Bank of England is expected to make a statement on Monday.

“The market remains very fragile and with the moves being driven by emotion it is very difficult to trade intraday,” said Antony Foster, head of G10 spot trading in EMEA at Nomura International Plc. “Parity for cable feels like a matter of time and while vols are off their highs there is no sense of relief in the price action this morning.”

Traders have ramped up bets on BOE rate increases, pricing in 190 basis points of tightening by the next policy meeting in November. They see the key rate peaking at 5.9% by August 2023.

At Bloomberg Economics, economist Dan Hanson said currency’s drop “will set alarm bells ringing at the central bank.” If it’s sustained, he sees the BOE raising its benchmark by 100 basis points.

The BOE previously tried to prop up the pound on Black Wednesday, using rate hikes and currency purchases when sterling crashed out of the Exchange Rate Mechanism, a system linking a number of European currencies. That defense, which took place 30 years ago this month, ultimately failed.

“We think that the BOE is too psychologically scarred from the events of 1992 to try defensive currency-related rate hikes,” said Chris Turner at ING. “What happens if the BOE hikes 300-500 basis points and GBP/USD ends up trading lower?”

Another option is direct currency intervention, but it doesn’t have enough reserves for a meaningful, sustained action. One possible response to the bond market moves is for the BOE to delay a planned sale of the gilts it bought under quantitative easing. That process is due to begin next week.

On Monday, 10-year yields rose as much as 37 basis points to 4.20%, and the five-year jumped 54 basis points to 4.61%.

Domestic-focused UK stocks including homebuilders, retailers and banks also slumped. The FTSE 250 index fell 1.5% as of 1:41 p.m. local time, extending a year-to-date plunge to 25%.

Sterling’s early-hours slump marked its biggest intraday drop since March 2020, when the Covid-19 outbreak roiled markets worldwide. A CME Group spokesperson confirmed that the dramatic fall triggered a 2-minute pause in trading of front-month British Pound futures contracts at 2:01 a.m. UK time, after a circuit-breaker kicked in.

Options markets see a onein chance of the pound reaching dollar parity this year. Truss will face a rebellion from Tory backbenchers against her tax cuts if the pound hits that level, the Telegraph reported Saturday.

“It would be foolish to rule out parity,” said Dean Turner, UK economist at UBS Private Banking. “If the market’s got the bit between its teeth, then fair value, or valuations or fundamentals are going to count for very little.”

Gerard Lyons, an external adviser to Prime Minister Truss, acknowledged on Monday that the market had concerns about government policy. But he said that while Kwarteng should reassure investors, he shouldn’t reverse course.

“He needs to reaffirm that tax cuts are only part of the story, not the full story,” Lyons said on Bloomberg Radio. “What they’re following is a supply-side agenda.”

(Updates with BOE comment in fifth paragraph, pricing throughout.)