By Mike Dolan
LONDON (Reuters) – The pound is once again taking the heat as UK financial markets wobble – often a sign of stress in a country highly dependent on foreign financing, but also potentially a safety valve to help resolve the problem.
The new year’s alarming spike in British government bond yields owes much to a sharp rise in global sovereign borrowing costs, with a U.S. Treasury yield surge ahead of the incoming Donald Trump administration the prime mover.
Indeed, the gaps between British ‘gilt’ yields and equivalent U.S. 10- and 30-year bonds have barely budged over the past three months.
Yet, nominal 30-year gilt yields this week hit their highest level in more than 25 years, while 10-year yields rose back to 2008 levels. This is creating all sorts of headaches for the new Labour government, which is already struggling to get its pro-growth agenda going and smarting from the poor reception given its tax-and-spend budget released in October.
And in a surprising turnaround, the pound suddenly stopped following gilt yields higher this week, as it had for much of the past year, and went in the opposite direction instead.
Only a month ago, the pound sailed to its highest level against the euro since 2016, after setting a similar milestone on a broader trade-weighed index in November.
Why the sudden volte-face – one that’s inevitably recalled 2022’s budget debacle under former Conservative Prime Minister Liz Truss?
Nothing seismic has changed on the UK domestic economic front in recent weeks to warrant this shift, even if many have been unnerved by reports this week of billionaire Trump adviser Elon Musk aiming to oust the UK Prime Minister.
As recently as December, many market players had been building sterling positions, prodded by the Bank of England’s relatively tight policy stance compared with the rest of Europe and a view that the UK was better positioned than the euro zone to withstand a Trump-inspired global trade war.
And while speculative net sterling positioning had fallen from its mid-year highs, it remained positive into yearend against a super-strong dollar.
A SIMPLE ANSWER?
But now many of those positions are being rapidly unwound, seemingly based on the view that British borrowing costs cannot keep rising ever higher along with U.S. Treasury yields without the UK taking a big economic and budgetary hit.
Unlike the buoyant U.S. economy, the UK arguably has far less ability to absorb this pain.
But is this a crisis?
There’s no sign yet of wider debt market dislocations, like those seen in 2022, and while implied pound volatility has risen, it remains half of what it was back then.
Still, a problem emanating from overseas can be potentially worse than a domestic one, simply because the government has little power to solve it.
And the combination of falling sterling and rising gilt yields is a red flag.
For some this is an old UK problem, perhaps compounded by the country’s exit from the European Union and the relatively small open economy’s increasing isolation. Its large current account and capital flow deficits leave it more vulnerable than other big economies to shifts in global financial conditions and market-based financing costs in particular.
Deutsche Bank (ETR:DBKGn)’s top currency strategist George Saravelos identified Britain’s long-standing balance of payments shortfall with the rest of the world as the villain of this story.
“The more a country relies on foreign financing for its domestic debt issuance, the more exposed it is to the global environment,” he told clients on Thursday. “From the perspective of external flows, the UK is one of the most vulnerable in the G10.”
So what’s the solution?
“The answer is simple: a weaker currency,” according to Saravelos, adding that this helps the country’s investment position because if UK assets become cheaper for foreign investors, this should attract capital and help narrow the current account gap.
The pound may have further to fall, he reckons, but its reversal will likely be “a natural equilibrating process” rather than a spiral or crisis.
That seems like quite a benign view of the week’s ructions. Others think these rumblings reflect the UK’s persistent inflation and weak growth compounded by recent employment tax rises. Some worry that a sharp bout of sterling weakness may irk inflation again and tie the BoE’s hands even further.
Either way, it does appear sterling’s period in the sun is over for now. But this fall from grace may well be what’s needed to resolve the problem and draw back overseas investors to higher-yielding gilts.
The opinions expressed here are those of the author, a columnist for Reuters.
(by Mike Dolan; Editing by Sonali Paul)
