The headlines in September have brought us back to reality after the summer break, with UK long-term borrowing costs soaring to the highest levels since the 1990s. This has made the economy seem almost uninvestable. However, amidst this turmoil, the pound is currently sitting at $1.36 against the dollar, which is up from a year ago and significantly higher than the $1.03 it reached after the ‘mini-Budget’. This disparity between bond markets and sterling signals raises questions about the overall economic outlook.
Are gilt market signals flashing red?
Looking at the data on gilts, it is clear that long-dated bond yields in the UK are higher than those in peer economies and exceed the levels seen after the 2022 mini-Budget crisis. The movements in the gilt market are influenced by various factors such as interest rates, inflation expectations, fiscal policy, and risk appetite. Following the mini-Budget crisis, the UK experienced significant disruptions in the bond market, leading to intervention by the Bank of England to maintain financial stability.
Currently, higher interest rates have caused yields to rise in the US and Europe, with 30-year borrowing costs increasing across the board. While BoE governor Andrew Bailey has downplayed these movements, emphasizing the limited impact of the 30-year bond rate on funding costs, the focus remains on 10-year yields as a more accurate reflection of government borrowing costs in the UK.
What the value of the pound is telling us
The value of sterling provides some reassurance, with analysts noting that the pound has performed well compared to other G10 currencies since the summer. This is partly due to the relatively high base rate in the UK, which remains at 4 percent. The uncertainty surrounding future interest rate cuts further attracts investors, leading to inflows into sterling and supporting its value.
However, the high interest rates are also a result of elevated inflation levels, which contribute to concerns in the gilt markets. The fear of eroding value due to inflation may deter investors from locking their money away for long periods. The changing dynamics of demand, quantitative tightening, and reliance on external investors all contribute to the uneasy atmosphere in the gilt market.
While analysts believe that the government will take measures to prevent a bond market meltdown and avoid a persistent risk premium in sterling, there are still expectations of mini episodes of volatility leading up to the Budget on 26 November. The UK markets are not in crisis, but there is a sense of discomfort and tension among investors as they navigate through uncertain economic conditions.