What a week that was in U.K. markets, for the economy and politics.
Sterling has managed to recover losses posted after the disastrous pitch by Chancellor Kwasi Kwarteng of his “special budget operation” a a week on Friday. Markets reacted positively to the BOE’s intervention to stabilise the long end of the Gilt curve and I think there are hopes that the market crash and political furore will see a U turn or partial reversal of policy by Truss and Kwarteng. We will have to await publication of more detailed fiscal plans by Kwarteng and team promised in November and the OBR forecast to boot. But irrespective of this it’s perhaps worth taking a few big picture takeouts as to what the past week is likely to mean - longer term implications.
First, irrespective of Kwarteng’s focus on growth, the chaotic rollout of his plans this week have damaged confidence. U.K. market rates have increased - short term Gilt yields are still around 80bps higher versus prior to the presentation of Kwarteng’s plans. Thousands of mortgage products are being reset, with rates inevitably being set higher. The U.K. government, households and business will have to pay more to borrow - likely at least 100bps, if not more depending on what markets predict this all means for longer term prospects for the U.K. Higher rates means lower growth - likely HMG will have to cut spending to account for higher debt service charges. It has just created a vicious cycle of higher rates and lower growth.
Second, confidence in policy making in the U.K. has been dealt yet another blow, and it was already struggling with the external message because of Brexit. Kwarteng is hoping to announce a big supply side reform package to kick start U.K. growth. But the poll ratings of the ruling Tories has collapsed so much - the opposition Labour Party has a near thirty point lead - there must be a question if Kwarteng and Truss will still be in office, whether they can get their plans thru parliament, and even if they do whether they will just end up losing the next elections due by December 2024. If they lose the elections any such reforms will just be rolled back.
Why should any international business trust Truss to relocate to the UK because of the supply side reforms if they don’t see her in office a few years down the line?
For international business tax levels fall way down the list of what is important to locate in a particular country to macro stability, certainly in the policy environment, availability of skilled, competitive labour and good infrastructure. The U.K. now scores poorly on all these - not helped by the fiasco observed this week.
Third, Kwasi’s unfunded tax cutting agenda did not add up - hence the market reaction this week. The plan now seems to be to cut spending to balance the books. This is likely to generate a whirlwind of industrial action - which has already been rising as a result of the cost of living crisis. Truss might think she is a Mrs Thatcher but she is certainly not and has zero political capital to deploy to take on striking workers and Unions. Strikes will just further disrupt economic activity causing further imbalances in public finances - and the vicious circle back to higher interest rates and lower growth again.
Fourth, confidence in both the BOE and other U.K. regulators has been badly shook this week. Questions need to be asked why the BOE has been so behind the curve in fighting inflation, and why it failed to address the now obvious structural weakness in the U.K. housing market - why do U.K. households not lock in longer term fixed mortgage rates, unlike their U.S. and European counterparts? The BOE was asleep on its watch. The fact they don’t means that the BOE now faces a nightmare situation of needing to hike rates to defend sterling and fight inflation but knowing it will not take much to crash the housing market. And why was nothing done to address the vulnerabilities exposed this week in the U.K. pension industry - how on earth did the pension industry come to the brink of collapse? Again regulators were asleep - I think all the focus on Brexit related issues and not on bread and butter regulation and supervision.
Now the BOE should get plaudits for intervening quickly to support the long end of the Gilt market to save the pension industry. But this action amounts to more QE - at a time when the BOE should be withdrawing liquidity thru QT. This all makes the BOE’s effort to fight inflation that much more difficult. They have been forced to pump liquidity into the system when they should be taking it out - ultimately just stalling the fight against inflation.
Fifth, with mortgage rates pushing higher, the U.K. housing market looks very fragile. Housing transactions are likely to fall off a cliff. Given strong links between the health of the housing market and retail sales and consumer confidence, likely we will see U.K. private consumption collapse - again feeding back to lower real GDP growth.
Sixth, sterling will remain in the spotlight and will be vulnerable given the BOE cannot hike rates in its defence given the fragility of the mortgage and housing market.
Seventh as as general point the crisis has demonstrated a lack of joined up thinking in government but also basic competency. Policy makers need to clearly understand the problems at hand, listen to sound advice and work with all the players in a team approach to delineate the best policy solutions. What comes out of all this is an astonishing level of arrogance and unwillingness to listen. But also a remarkable failure to understand markets - almost a last assumption that markets will just accept anything that a Tory government tries to force thru. Basic planning seems to be lacking. Poor - non existent communication. Where were the Chancellor and prime minister in the first few days of the crisis? Kwasi seemed to be down the pub, in the afternoon after presenting his special fiscal operation. That’s just unforgivable when the nation is in crisis. How does that inspire?
In conclusion, Kwarteng talks about supply side reforms but before that the U.K. needs basic macro stability - which is sadly lacking at present. It’s hard to see the current team recovering credibility - change is required.
Though American, I watch the UK, and all global markets actively for my role in FX. However, while the Truss/Kwarteng plans have not been well received, given the hand they were dealt, more than a decade of insanely easy monetary policy with zero interest rates and QE, as well as the structural economic issues that were created by government responses to Covid, It is not clear that a more orthodox process would have resulted in any better outcome. After all, the orthodox policies are the ones that got us to where we are. remember transitory inflation? remember flattening the curve of covid infection? remember the strong belief in the great moderation as a result of brilliant central banking?
All I know, and it is equally true in the US and most of the world, is that the previous decade's worth of policies have not borne out the promises made, so perhaps something new was the best they had.