Markets are now dealing with British bonds such as Greek and Italian debt

CNN Business

The pound may have stopped its price Reckless crash towards parity In US dollars, but Damage to the UK economy Triggered by Prime Minister Liz Truss’s massive tax cut gamble is still pervasive in financial markets.

Sterling settled early Tuesday to trade near $1.08, bouncing off Monday’s low of around $1.03. The benchmark 10-year UK government bond rate also rose slightly.

But few analysts believe the volatility is over yet. Bond prices, in particular, remain unstable. And when the dust settles, the country will have to contend with a sharp increase in borrowing costs, adding pressure to an economy already struggling with 10% inflation and the beginnings of a recession.

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

Dropping in the pound is bad enough. This will increase import costs, adding pressure on the Bank of England to raise interest rates faster and higher. However, the extraordinary collapse in government bond prices, and the corresponding jump in yields, could be even worse.

UK medium-term borrowing costs, as measured by the yield on five-year bonds, are higher than those of Greece and Italy, two countries seen as riskier bets for investors due to their high debt levels.

Debt as a percentage of economic output in Greece was 189% in March, while the Italian debt-to-GDP ratio was around 153%. In the UK, this number was close to 100%.

Bond yields jumped around the world as major central banks launched a fierce campaign to slow inflation, raising rates at a brisk pace.

British government debt has been sold off sharply, in part because Truss and her team have said they will need to borrow more to fund their economic programme, which includes the biggest tax cuts in 50 years and covers the energy bills of millions of families and businesses. This winter.

The need to raise more money from investors comes as the Bank of England is set to begin selling some of its holdings of government bonds, which increased during the early days of the pandemic.

Previously, markets absorbed about 100 billion pounds ($108 billion) of British bonds annually, according to Ross Walker, chief UK economist at NatWest Markets. With the Bank of England switching from buyer to seller, and the UK government borrowing more, supply will rise to around 300 billion pounds ($323 billion), he estimated.

“A significant rise in returns was always warranted,” Walker said, noting that the world was “moving into a different financial and monetary environment.”

However, the sudden increase was exacerbated by the crisis of confidence About the next direction of the UK economy. Investors are concerned that the government’s attempt to boost growth by boosting demand runs counter to the objectives of the Bank of England, which is trying to cut demand so it can control inflation.

At the beginning of August, the yield on the UK 5-year bond was 1.55%. And on Tuesday morning, it was 4.27%. This is a huge move in markets where changes usually occur in small parts of a percentage.

It is not yet clear where the returns will settle, although there is consensus that they will remain high. Much may depend on future communications from the Bank of England, which has said it will raise interest rates to fight inflation as needed, but the central bank is not due to meet until November.

Investors will also closely watch the government’s comments. Kwasi Quarting, Britain’s finance minister, has promised to reveal more details about the government’s approach to ensuring debt sustainability, while also indicating that additional tax cuts may be on the horizon. In a meeting with anxious investors Tuesday, he reiterated the British government’s commitment to “financial sustainability”.

“We are still at a stage where markets in general are trying to create new equilibrium values,” Walker said.

However, higher borrowing costs will have consequences for both the government and households. Higher revenues mean the government will have to pay more debt servicing costs, cut spending or raise taxes to find the money to do so. The higher rates from the Bank of England will make it more expensive for businesses and home buyers to get loans.

“This will make the UK’s fiscal constraints tighter,” said Andrew Wishart, chief economist at Capital Economics. “This will significantly increase interest costs.”

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

People with mortgages will also pay the price. UK lenders suspended the sale of new mortgage products on Monday while they waited for volatility to ease. When business resumes, the cost of financing a home purchase is expected to rise. Those who need to be refinanced are also in trouble.

If the Bank of England raises interest rates to 6%, as some market participants now expect, anyone who refinances a 20-year fixed-rate mortgage of £146,000 ($157k) would have to pay an additional £309 ($333) ) per month, according to investment firm AJ Bell. That’s £108 ($116) more than had been forecast prior to last Friday.

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