The UK's currency - sound as a pound?
Sterling is falling as gilt yields rise - is this just a British problem or a symptom of rising volatility in the currency markets at large?
Otto von Bismarck, the walrus-moustached architect of the 2nd German Reich, once said, “never believe anything in politics until it has been officially denied.” Yesterday, the UK Treasury dismissed as ‘pure speculation’ that rising bond yields had wiped out the government’s fiscal head room and that Chancellor Reeve might have to come back later this year with yet more tax rises to plug the gap1.
10 years ago, 30 year UK government bonds (gilts) yielded just under 2.5%. A decade on, they are currently yielding 5.37%. The difference? Back in 2015, the Bank of England (BoE) base rate was 0.5% and its balance sheet was steady at just under £400b.
Today, the base rate is 4.75% and the BoE’s balance sheet is £840b, the latter down from a peak of £1.1b as the central bank unwinds its pandemic-era bond purchases. The new Labour government is suddenly finding that its fiscal position is a little harder to manage when money isn’t free and the BoE isn’t hoovering up everything in the bond market.
Market headlines tend to reflect momentum, especially when yields spike and currencies tumble. Is this Labour’s fault, or have they simply added fuel to an already existing fire of excessive debt and deficit spending?
Britain’s long decline from imperial and industrial powerhouse to also-ran can be tracked through the strength of the pound. On the eve of the First World War, sterling briefly spiked above $6 in a classic flight to safety trade. It nearly touched parity with the dollar in the mid-1980s, and again during the ill-fated salad days of Liz Truss’s attempt to implement widescale tax cuts with no corresponding cut in government spending. At the time of writing, the pounds buys $1.23, having fallen from $1.34 last September.
Britain’s monetary adventures in the 1970s began with the famous Barber budget of 1972, an attempt to supercharge growth through increased deficit spending and tax cuts. Unemployment did fall, but so did the pound, and with it the UK experienced an inflation surge, abetted in no small part by the 1973 oil crisis.
Events came to a head in 1976 when the Labour government, inheriting twin deficits and an inflation problem from the outgoing Tories, was forced to go cap in hand to the IMF for a £3.9b loan to prop up the pound. The then chancellor, Denis Healey (see photo above), later claimed that poor Treasury forecasting made the situation look worse and that the loan was never needed. Only half the money was drawn, and the loan was paid back in May 1979.
The price of the 1976 IMF loan was spending cuts, the goal being to stabilise public finances and by so doing to stabilise the pound. There is clearly no question of the current UK government going to the IMF, but the question of having to cut government spending to stabilise the bond market may yet arise in 2025.
In her October 2024 budget, Chancellor Reeve announced an extra £142b of borrowing in the 2024/5 fiscal year along with tax increases of ~£40b. With the rise in gilt yields, there are claims that the government’s fiscal headroom, originally estimated at £10b, has now dwindled to just £1b2. If the government has to borrow more or raise taxes further, markets will almost certainly push yields higher and the pound lower, driving inflation higher at the same time.
Just prior to the October budget, Market Depth commented that achieving growth through tax hikes and more borrowing was likely a fool’s errand (see link above). To be forced by market pressure to cut spending to stabilise the public finances would be a huge embarrassment for the new Labour government, and one assumes that they will try to double down first before having to bow to the bond vigilantes and currency speculators.
Given the close link between politics and the domestic economy, the press tends to be somewhat parochial when analysing financial markets. The current spike in bond yields and fall in the pound will be laid at the government’s feet, even if there are other, wider forces at work.
Without wanting to be an apologist for Liz Truss’s political naivety, it is worth noting that in 2022, the pound started the year at around $1.36 and had already fallen to $1.16 when she took office on the 6th September. The subsequent drop in sterling to near parity to the dollar was all her, but one should look at 2022 as much in terms of dollar strength as sterling weakness - the Japanese yen had for example been taking a beating all year too.
Unless there is a truly idiosyncratic event such as Brexit, bond markets often tend to move in unison over the medium to long term. This is in part because of the way our global monetary system functions, particularly with respect to the central role the US dollar plays as a reserve currency.
The graph above shows the US 10yr Treasury yield. On the eve of the first rate cut by the Federal Reserve (17/09/2024), the 10yr traded at 3.62%, and is now over 100 bps higher at 4.68%. The Fed has in the meantime cut interest rates by 100 basis points.
It seems the market is giving the thumbs down either to the Fed’s attempt to curb inflation, the wider issue of the parlous state of US public finances (debt to GDP north of 120% and a deficit of ~7%), the ability of the incoming Trump government to put things right, or possibly all three at once.
While the UK press is going to town with the Labour government, one ought to be aware of the extreme uncertainty being generated in the run up to President Trump’s return to office. A lack of clarity about the extent of his tariff policy, as well as worryingly belligerent rhetoric about Canada, Greenland, the Panama Canal and a number of other issues, are all sources of volatility for the bond and currency markets, both in the US and elsewhere.
2025 may yet prove to be a year of extreme currency market volatility. While the UK’s fiscal position is slightly less bad than America’s, it also has a government which is proving to be distinctly less market- and business-friendly than many hoped. Either way, Chancellor Reeve et al will have to navigate not only the consequences of a likely ill-advised tax-and-spend approach to growth, but also an international macroeconomic backdrop of heightened uncertainty.
The post-financial crisis approach to market turmoil has been for the central bank to step in to buy government bonds to stabilise yields. One can control the price of money (ie government bond yields) or the quantity, but not both. As Market Depth commented back in 2023 (see link above), in an era of higher inflation, policies like quantitative easing or other similar open-market activities may in fact make the situation worse, especially with respect to currency weakness.
For a small, open economy like the UK, the pound would likely be the principal casualty of a force BoE intervention. Perhaps the UK’s only hope is for President Trump and his Secretary of State for the Treasury Scott Bessant to pursue an active policy to weaken the dollar, thereby giving sterling a break. Fingers crossed, Ms Reeve.
Treasury forced to intervene in market turmoil, The Telegraph, 09/01/2025.
Ian Smith & Sam Fleming, UK long-term borrowing costs hit highest level since 1998, Financial Times 08/01/2025