Could a 25-minute statement by Britain’s new chancellor of the exchequer spook the financial market up to urgent step in by the Bank of England to restore market functioning?
This is what happened earlier this week on UK gilt markets, and what put UK under global attention for instability risks ever since Brexit. Someone was and is ready to point fingers towards financial markets as guilty of the record volatility experienced in the last days, but reasons are more consistent rather than just fear of the investors.
The pound crashed to its lowest level against the dollar and sales were heavy on UK government bonds. The gilt yields surged because the market was impressed by the prodigal fiscal measures, centred on cutting taxes especially to the wealthiest, with vague supply-side reforms and public finance approach to pay for them.
Two things scare the markets. On one hand, the tax cut program will be financed with an increase in public debt, issuing more government bonds. And the government announced so at a time when the Bank of England, to lower inflation, was preparing its quantitative tightening plan, to sell on the market part of the government bonds it has bought in past years. But these concomitant declarations could cause oversupply and an increase in the cost of debt: at a time like this a very expansive measure is likely to become counterproductive and to make inflation soar even higher.
Indeed, the market bets on an extra-rise in rates by the central bank, to counter the manoeuvre and cool the same economy that the government risks to overheat.
The Bank of England has already said it will “not hesitate” to hike interest rates to protect the pound and stem surging prices. Some economists have predicted the Bank of England will raise the interest rate from the current 2.25% to 5.8% by next spring.
In particular, the BoE is monitoring developments in financial markets very closely considering the significant repricing of U.K. and global financial assets. This repricing has become more significant in the past days, and it is particularly affecting long-dated UK government debt. In line with its financial stability objective, the Bank of England stands ready to restore market functioning and reduce any risks from contagion to credit conditions for UK households and businesses, it added.
As a matter of fact, reports emerged on Wednesday 28th that recent sharp declines in gilts and the pound had left some U.K. pension funds facing margin calls of as much as £100 million each. Also, several U.K. banks had suspended mortgage offers after the bond market volatility left them struggling to price home loans: the total number of mortgage products available has dropped from 3,961 on Friday 23rd to 2,661 on Wednesday 28th.
To sum all it up, the BoE decision to postpone quantitative tightening before it even started, and to launch a fresh quantitative easing program is certainly remarkable, because it lays bare the seriousness of the financial stability risks emerging with the uncontrolled bond market backlash against reckless UK fiscal plans: £45 billion of debt-funded tax cuts at a time when inflation is running at a near 40-year high of 9,9%, that was even lambasted by the International Monetary Fund.
The market reaction to the budget means that it will hurt growth, rather than boost it. The weaker pound causes higher imported inflation, eroding real incomes. The BoE has resisted pressure for an emergency rate rise, but it has signalled unequivocally that a big increase will come in November. That will add to the government’s own interest payments and harm people with mortgages.
What emerges from these recent events is that growth depends on a framework of policy stability, and to sound public finances. The market reaction to British fiscal policy should therefore not be surprising.
But even the non-reaction of the markets gives an interesting perspective: the unharmed election of the far-right party as the primary political party with the Italian vote, should not surprise: the new Government will have to win his way with its ministers and its executive program.
This would not avoid any financial market reactions to the new Italian government settlement, as it did not for the English government of Liz Truss. If the new government will present an expansionary fiscal policy, the equation with markets reaction is not straightforward since it will depend on the reliability and sustainability of the budget.
Apparently, markets do not judge based on political colours: what matters to investors is how programs are presented and managed, not who design them. At least without significant harm to their own interests.
Sources: BCC, Financial Times, The Economist, IlSole24Ore
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