Brace yourself for a bumpy ride, says HAMISH MCRAE: Markets are deeply skeptical of Britain’s ability to steer the economy and the new PM faces it
We will have a new Prime Minister and a new Cabinet this week. The Prime Minister has gained the confidence of the rather small constituency of Tory members.
The new government must now win the trust of a much larger one: that of the global financial markets. For it will face a brutal truth. Markets are deeply skeptical of their ability to run the economy successfully, and the government will have to live with that judgment, justified or not.
To get a feel for this skepticism look at what has happened to sterling and gilt yields. The pound has fallen sharply against the dollar and is below $1.16, its lowest since March 2020.
Spinning the wheel: The new government must win the trust of the global financial markets
True, this is partly related to the dollar’s safe haven status, as the euro is at par and the yen is at a 24-year low. But sterling has also fallen against the euro in recent days and there are bleak forecasts for it to fall further. For gilts, the 10-year yield has risen to 2.9%, the highest since 2013. All bond yields have risen sharply in recent days, with corresponding US Treasuries at 3.2% and German Bunds at 1.5%.
But while almost every other government bond yield is slightly below its previous peak in June, UK yields are higher. In relative terms, the UK is in a less favorable position than it was a few months ago.
This is important for very practical reasons. A weak currency imports inflation. If the pound were back above $1.35 as it was in January we would be buying oil much cheaper and fuel at the pump would be around 150p a liter. Higher inflation, in addition to affecting our standard of living, increases the cost of financing public debt in two ways. It drives up the cost of the index-linked part, while higher interest rates obviously drive up the cost of the rest.
This unpleasant story has another twist. Markets are now expecting the Bank of England’s interest rate peak next summer to be above 4%, well above the bank’s own forecast of 3%.
If the markets are right, this would suggest that a two-year fixed-rate mortgage would cost more than 5 percent. But the prospect of these higher interest rates isn’t attracting money into sterling, quite the opposite.
Why? I don’t believe in the idea of the pound going into some sort of death spiral to the all-time low of $1.05 it fell to in February 1985. Nor do I accept the fear in the markets that the new government will be irresponsible with the nation’s finances. But her mood has undoubtedly deteriorated in recent weeks. So the new government needs to restore confidence. And this amid broader concerns that the cost of inflation will lead to a severe global recession next year.
Rationally, the UK is no worse off than other developed countries, I would say better than most. But it will take time to get that message across, and in the meantime, market sentiment will darken rather than brighten. It will darken in part because the turning point in inflation is not yet in sight. At the moment, every inflation forecast is worse than the one before. Our run in the UK is particularly alarming, but the same thing is happening everywhere. However, the rise in inflation is just one element of the broader transition from the world of easy money to, well, tighter money.
Take the rise in bond yields mentioned above. Bond prices move inversely with yields, so when interest rates rise, their price falls. Last week, the global Bloomberg index of government and investment-grade bonds fell 20 percent from its peak in January 2021, technically meaning there is a bear market in bonds.
This is the first time this has happened since they launched this index in 1990, and in my own quick assessment, there hasn’t been a bear market in bonds since the 1980’s. Money managers have seen bear markets in stocks but not in bonds.
So it will be a bumpy ride for our new government. But the markets would do well not to underestimate the new cabinet – it will have been working hard on its economic plans for weeks. And whatever our policy, we should wish her well at this crucial time.