The markets were quick to respond to Kwasi Kwarteng’s ‘shock and awe’ mini-budget.
The most spectacular reaction by far was in the bond market where yields on gilts (UK government IOUs) immediately spiked higher on the prospect of a big surge in government borrowing.
Mr Kwarteng announced some £45bn worth of tax cuts and, along with the sums the government will be spending to protect households and businesses from the impact of higher energy bills, it means there is going to be more borrowing this year than previously announced.
Sure enough, the Treasury said it will be asking the Debt Management Office – the Treasury agency that manages the national debt and oversees the government’s borrowings from the markets – to raise an additional £72bn in gilt sales this year.
This will be done via additional gilt sales of £62.4bn, taking the planned total in 2022-23 to £193.9bn, along with additional sales of Treasury bills of £10bn.
The bond market delivered its response at once.
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The yield (an implied borrowing cost for the government) on 10-year gilts, which was 3.495% at the close of business on Thursday evening surged to as much as 3.842% at one stage – a level not seen since April 2011.
Similarly, the yield on 5-year gilts, which on Thursday evening stood at 3.353%, surged at one point to 4.047% – a level last seen in October 2008. It is the biggest one-day move seen in 5-year gilts in 31 years. Meanwhile the yield on 2-year gilts rose to their highest level since October 2008 in their biggest one-day jump in 13 years.
These are big, significant moves which show that investors are demanding a higher premium to reflect the risk of lending money to the UK.
In fairness, the UK is not the only country to have seen an increase in its bond yields in recent weeks, with the yield on US Treasury bonds and even German government bunds recently rising to multi-year highs. But the increase in gilt yields is nonetheless pretty dramatic.
As David Page, head of macro research at Axa Investment Management, put it: “This [mini-budget] is clearly something that suggests a significant amount of extra gilt borrowing, but at the same time it’s fiscal stimulus at a time when the Bank of England is already worried about aggregate demand being too high, and it’s highly likely to force the Bank of England to raise rates even more than we thought they were going to otherwise.”
The pound has also reacted quite dramatically.
Having traded on Thursday evening at $1.1257, the pound fell at one point to $1.1064, a fresh 37-year low. Now it is only fair to point out that lots of currencies have been hitting multi-year lows in recent sessions against the US dollar, most notably the Japanese yen, the South Korean won, the Indian rupee and the Australian dollar, so sterling is far from unique in this regard.
But it is also worth noting that the pound also fell by 0.75% against the euro on the mini-budget.
On equity markets, the FTSE 100 has been trading broadly in line with continental European indices.
In essence, Mr Kwarteng has gone for a high risk, high reward strategy. By cutting taxes and improving incentives for businesses to invest, the chancellor is unashamedly seeking to pursue growth.
What the gilt market is worried about, though, is this amount of fiscal loosening at a time when there is monetary tightening being carried out by the Bank of England.
As Trevor Greetham, head of multi asset at Royal London Asset Management, put it: “Action to help struggling households and businesses pay their heating bills this winter was essential, but the scale of the tax cuts and spending increases in this announcement is breath-taking.
“Arguably, a significant, unfunded fiscal stimulus package like this would have made economic sense after the deflationary global financial crisis, when borrowing costs were low and private sector balance sheets were deleveraging.
“Now with spare capacity non-existent, inflation at a forty year high and the Bank of England trying to cool things down, we are likely to see a policy tug of war reminiscent of the stop-go 1970s. Investors should be prepared for a bumpy ride.”
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Early evidence of bond vigilante activity
The UK is suddenly about to become a lot more interesting to economists and bond traders.
The term ‘bond vigilantes’ was coined in the 1990s to describe the way that bond investors could effectively impose fiscal discipline on governments by selling their bonds – forcing up their implied borrowing costs – if they thought those governments were being too imprudent.
Their influence was famously described by James Carville, an advisor to the then US president Bill Clinton, thus: “I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter.
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“But now I would like to come back as the bond market. You can intimidate everybody.”
Governments around the world, including Germany and France, are splurging vast amounts of money in an attempt to navigate their way through the energy crisis but few are cutting taxes or raising borrowing as aggressively as the UK is at the same time.
The US has been able to borrow vast sums over the years because it can borrow in the world’s reserve currency – the mighty dollar.
The bond vigilantes tried to take on countries like Italy, Greece and Spain during the eurozone debt crisis but decisive action from the European Central Bank under its then president, Mario Draghi, was powerful enough to keep them at bay.
But Japan, the world’s most indebted advanced economy, is now starting to experience severe strain – as shown by the way its central bank has this week desperately been intervening for the first time in 24 years to defend the yen.
And there is a chance – perhaps – that the bond vigilantes may now seek to impose their discipline on the UK government.
Today’s movement in gilt yields suggests it is happening.
