Markets now view UK bonds as Greek and Italian debt

CNN Business

The pound may have halted its long slide towards parity with the US dollar, but the damage to the UK economy from Prime Minister Liz Truss’s giant tax-cut gamble is still rippling through financial markets.

Sterling steadied on Tuesday to trade near $1.08 and hit a record near $1.03 on Monday. The price of the UK’s benchmark 10-year government bond also rose slightly.

But few analysts believe the volatility is over yet. Bond prices in particular remain volatile. 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 around 10% inflation and the onset of recession.

“This is a situation where the government’s borrowing costs – and therefore all our borrowing costs – are incredibly vulnerable,” economist Mohamed El-Erian, an adviser to Allianz, told the BBC on Tuesday.

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

Medium-term borrowing costs in the UK, as measured by five-year bond yields, have risen above those in Greece and Italy, two countries known as riskier bets for investors because of their high debt levels.

Greece’s debt-to-GDP ratio was 189% in March, while Italy’s debt-to-GDP ratio was about 153%. In Great Britain, the figure was almost 100%.

Bond yields around the world rose, with interest rates rising sharply as top central banks launched an aggressive campaign to slow inflation.

UK government debt sold off sharply, but in part because Truss and his team said they would borrow more this winter to fund the biggest tax cuts in 50 years and economic programs that would curb energy costs for millions of households and businesses.

The need to raise more money from investors is due to the Bank of England starting to sell some of the government bonds it raised in the early days of the pandemic.

Previously, markets absorbed about 100 billion pounds ($108 billion) of U.K. bonds each year, according to Ross Walker, chief U.K. economist at NatWest Markets. As the Bank of England switches from buyer to seller and the UK government borrows more, the supply will rise to around 300 billion pounds ($323 billion).

“Significant growth in income was always warranted,” Walker said, noting that the world was “moving into a different financial and monetary environment.”

Again, the leap was fueled by a crisis of confidence On where the UK economy goes next. Investors are worried that the government’s attempt to boost growth by boosting demand is at odds with the Bank of England’s aim of reducing demand to control inflation.

In early August, the UK 5-year gilt yield was 1.55%. It was at 4.27% on Tuesday morning. In markets where changes typically occur in fractions of a percent, this is a big move.

It is not yet known where the revenues will settle, although there is a 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 if necessary to fight inflation, but the central bank is not scheduled to meet until November.

Investors will also closely monitor the government’s comments. UK Finance Minister Kwasi Kwarteng has promised to provide more details on the government’s approach to debt sustainability, while also hinting that further tax cuts may be on the horizon. In a meeting with worried investors on Tuesday, he reiterated the British government’s “commitment to fiscal sustainability”.

“We’re still in a phase where markets are generally trying to establish new equilibrium values,” Walker said.

However, higher borrowing costs will have consequences for both the government and households. Rising revenues mean the government will have to pay more in debt service, cut spending or raise taxes to find the money to do so. Higher Bank of England rates will make it more expensive for business and home buyers to borrow.

“This will create an even tighter UK fiscal constraint,” said Andrew Wishart, chief economist at Capital Economics. “This will significantly increase their interest costs.”

The Resolution Foundation, a think-tank critical of the government’s plans, estimates that the moves in the bond market will add about 14 billion pounds ($15.1 billion) to borrowing costs. By 2026-2027.

People with mortgages will also pay the price. UK lenders halted sales of new mortgage products on Monday as they expect volatility to ease. As business recovers, home purchase financing costs are expected to rise. Those who need refinancing are also struggling.

If the Bank of England raises interest rates to 6%, as some market participants now expect, someone refinancing a £146,000 ($157,000) 20-year fixed-rate mortgage will have to pay an extra £309 ($333) a month. according to investment firm AJ Bell. That’s 108 pounds ($116) more than estimated as of last Friday.

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