Author: Mike Dolan
LONDON (Reuters) – The pound is heating up again as Britain’s financial markets wobble – often a sign of stress in a country heavily dependent on foreign funding, but also a potential safety valve to help deal with problems.
The New Year’s alarming spike in UK government bond yields owes much to a sharp rise in global government borrowing costs, with a jump in US Treasury yields ahead of the incoming administration of Donald Trump as the main driver.
Indeed, the spreads between UK ‘gilt’ yields and equivalent US 10- and 30-year bonds have barely narrowed over the past three months.
Still, nominal 30-year arable yields hit their highest level in more than 25 years this week, while 10-year yields rose back to 2008 levels. This creates all sorts of headaches for the new Labor government, which is already struggling to get its pro-growth agenda under way and is annoyed by the poor reception to the tax and spending budget released in October.
And in a surprising twist, the pound suddenly stopped tracking higher yields this week, as it had for most of last year, and went in the opposite direction.
Just a month ago, the pound sailed to its highest level against the euro since 2016, after setting a similar milestone on the broader trade-weighted index in November.
Why the sudden about-face – one that inevitably recalls the 2022 budget debacle under former Conservative Prime Minister Liz Truss?
Nothing has seismically changed on the UK’s domestic economic front in recent weeks to warrant this change, even if many were alarmed by this week’s reports of billionaire Trump adviser Elon Musk intent on ousting the British prime minister.
Back in December, many market players were building sterling positions, driven by the Bank of England’s relatively tight policy stance compared to the rest of Europe and the view that the UK is better placed than the eurozone to withstand a global situation inspired by the Trump trade war.
And while sterling’s speculative net positioning fell from its mid-year highs, it remained positive for the rest of the year against the super-strong dollar.
SIMPLE ANSWER?
But now many of those positions are being rapidly withdrawn, apparently based on the view that Britain’s borrowing costs cannot keep rising alongside US government bond yields without the UK taking a major economic and budgetary hit.
Unlike the buoyant US economy, the UK arguably has far less capacity to absorb this pain.
But is this a crisis?
There are no signs yet of wider debt market dislocations, such as those seen in 2022, and while the implied volatility of the pound has risen, it remains half of what it was then.
However, a problem coming from abroad can be potentially worse than a problem at home, 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 problem of the UK, which is perhaps even more complicated by the country’s exit from the European Union and the increasing isolation of a relatively small open economy. Its large current account and capital flow deficits make it more vulnerable than other major economies to changes in global financial conditions, particularly market financing costs.
Deutsche Bank (ETR:) chief currency strategist George Saravelos has identified Britain’s long-running balance of payments deficit against the rest of the world as the villain in this story.
“The more a country relies on foreign financing to issue domestic debt, the more exposed it is to the global environment,” he told clients on Thursday. “From an external flows perspective, the UK is one of the most vulnerable in the G10.”
So what is 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 to fall further, he believes, but its turnaround is likely to be a “natural rebalancing process” rather than a spiral or crisis.
That seems like a pretty benign view of weekly ructions. Others think the noise reflects persistent inflation and weak growth in the UK, which has been exacerbated by recent increases in employment tax. Some worry that a sudden burst of weakening in the pound could reignite inflation and further tie the BoE’s hands.
Either way, Sterling’s time in the sun appears to be over for now. But this fall from grace could be just what is needed to fix the problem and attract foreign investors back to higher-yielding gilts.
The opinions expressed here are those of the author, a Reuters columnist.
(Mike Dolan; Editing by Sonali Paul)
