Markets now treat UK bonds like Greek and Italian debt

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London
CNN Business

The pound may have interrupted its puzzle head down towards parity with the US dollar, but the damage to the UK economy triggered by Prime Minister Liz Truss’ huge bet on lowering taxes continues to reverberate through financial markets.

The pound stabilized early on Tuesday to trade near $1.08, rebounding from Monday’s record low of around $1.03. The price of benchmark 10-year UK government bonds also rose slightly.

But few analysts think the volatility is over yet. Bond prices, in particular, remain volatile. And when the dust settles, the country will be forced to deal with a sharp rise in borrowing costs, adding pressure to an economy already struggling with near double-digit inflation and the onset of a recession.

“This is a situation where government borrowing costs – and therefore all of our borrowing costs – are incredibly vulnerable,” economist Mohamed El-Erian, an adviser to Allianz, told the BBC on Tuesday.

The pound’s fall is bad enough. This will drive up import costs, adding pressure on the Bank of England to raise interest rates faster and higher. Yet the extraordinary collapse in government bond prices and corresponding rise in yields could be even worse.

Medium-term borrowing costs in the UK, as measured by five-year bond yields, have exceeded those of Greece and Italy, two countries notoriously seen as riskier bets for investors due to their high level of indebtedness.

Greece’s debt as a percentage of economic output stood at 189% in March, while Italy’s debt-to-GDP ratio was nearly 153%. In the UK, this figure was almost 100%.

Bond yields around the world jumped as major central banks launched an aggressive campaign to curb inflation, raising rates at a rapid pace.

However, UK government debt has sold off sharply, in part because Truss and his team have said they will need to borrow more to fund their economic program, which includes the biggest tax cuts in 50 years and capping energy bills of millions of households and businesses. This winter.

The need to raise more money from investors comes just as the Bank of England is due to start selling some of its holdings of government bonds, which it stepped up at the start of the pandemic.

Previously, markets absorbed around £100bn ($108bn) of UK bonds a year, according to Ross Walker, chief UK economist at NatWest Markets. As the Bank of England switches from buyer to seller and the UK government borrows more, the supply will climb to around £300 billion ($323 billion), he estimated.

“A significant increase in yields was still warranted,” Walker said, noting that the world is “moving to a different fiscal and monetary environment.”

Yet the spike was exacerbated by a crisis of confidence about the next direction the UK economy will take. Investors fear that the government’s attempt to stimulate growth by strengthening demand will run counter to the objectives of the Bank of England, which is trying to reduce demand in order to control inflation.

In early August, the yield on UK 5-year gilts was 1.55%. Tuesday morning, it stood at 4.27%. This is a huge move in markets where changes usually occur in tiny fractions of a percent.

It is not yet clear where yields will settle, although there is consensus that they will remain high. Much could hinge on future communications from the Bank of England, which has said it will raise interest rates to fight inflation if necessary, but the central bank is not expected to meet until November.

Investors will also be watching government comments closely. Kwasi Kwarteng, Britain’s finance minister, has promised to release more details on the government’s approach to ensuring debt sustainability, while also indicating that further tax cuts could be on the horizon. In a meeting with anxious investors on Tuesday, he reiterated the UK government’s “commitment to fiscal sustainability”.

“We’re still in a phase where markets in general are trying to establish new equilibrium values,” Walker said.

Yet higher borrowing costs will have consequences for both government and households. Rising yields mean the government will have to fork out more to service debt, cut spending or raise taxes to find the money needed. Higher Bank of England rates will make it more expensive for businesses and buyers to take out loans.

“This is going to make the budget constraint that the UK finds itself in even tighter,” said Andrew Wishart, senior economist at Capital Economics. “This will significantly increase their interest costs.”

The Resolution Foundation, a think tank that has criticized the government’s plans, estimates the bond market moves will add around £14 billion ($15.1 billion) to borrowing costs. by 2026 to 2027.

People with mortgages will also pay the price. British lenders suspended the sale of new mortgage products on Monday until volatility subsides. When business picks up, the cost of financing a home purchase is expected to skyrocket. Those who need to refinance are also struggling.

If the Bank of England raises interest rates to 6%, as some market participants expect, someone refinancing a £146,000 ($157,000) 20-year fixed-rate mortgage will have to pay An additional £309 ($333) per month, according to investment firm AJ Bell. That’s £108 ($116) more than expected before last Friday.

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