By Mike Dolan
LONDON (Reuters) – The pound is facing fresh criticism as British financial markets wobble – often a sign of stress in a country heavily reliant on foreign financing but also potentially a safety valve to fix the problem.
The alarming rise in UK government bond yields in the new year is largely due to a sharp rise in global government borrowing costs, driven by a rise in US government bond yields ahead of Donald Trump’s incoming administration.
The gap between UK government bonds and comparable 10- and 30-year US government bonds has barely narrowed in the past three months.
Yet nominal 30-year government bond yields reached their highest level in more than 25 years this week, while 10-year bond yields rose back to 2008 levels. This poses all kinds of headaches for the new Labor government, which is already struggling to get its pro-growth agenda going and is suffering from the poor reception of the tax and expenditure budget released in October.
And in a surprise turnaround, the pound this week suddenly stopped following higher government bond yields, as it had done for much of the past year, and instead headed in the opposite direction.
Just a month ago, the pound hit its highest level against the euro since 2016, after hitting a similar milestone on a broader trading index in November.
Why this sudden reversal – one inevitably reminiscent of the 2022 budget debacle under former Conservative Prime Minister Liz Truss?
There has been nothing seismic change on Britain’s domestic economic front in recent weeks to warrant this shift, even if many have been unnerved by reports this week of billionaire Trump adviser Elon Musk seeking to oust the British prime minister.
As late as December, many market players had built up positions in sterling, spurred by the Bank of England’s relatively tough policy compared to the rest of Europe and the view that Britain was better positioned than the eurozone to cope to a Trump-inspired global crisis. trade war.
And while net sterling’s speculative positioning had fallen from mid-year highs, it remained positive against a super-strong dollar through the end of the year.
A SIMPLE ANSWER?
But now many of these positions are being rapidly unwound, apparently based on the view that British borrowing costs cannot continue to rise, along with US government bond yields, without Britain taking a major economic and budgetary hit.
In contrast to the booming US economy, Britain arguably has far less ability to absorb this pain.
But is this a crisis?
There are no signs yet of a wider debt market disruption like that in 2022, and although the pound’s implied volatility has risen, it still remains half of what it was then.
Yet a problem that comes from abroad can potentially be worse than a domestic problem, simply because the government has little power to solve it.
And the combination of falling British pounds and rising government bond yields is a warning sign.
For some, this is an old British problem, perhaps exacerbated by the country’s departure from the European Union and the increasing isolation of its relatively small open economy. Large current account deficits and capital flows make the country more vulnerable than other major economies to shifts in global financial conditions and in particular market-based financing costs.
Deutsche Bank (ETR:)’s chief currency strategist, George Saravelos, identified Britain’s and the rest of the world’s long-standing balance of payments deficit as the villain of this story.
“The more a country depends on foreign financing for its domestic debt issuance, the more exposed it is to the global environment,” he told clients on Thursday. “From the perspective of external flows, Britain is one of the most vulnerable in the G10.”
So what’s the solution?
“The answer is simple: a weaker currency,” Saravelos said, adding that this will benefit the country’s investment position. If UK assets become cheaper for foreign investors, this should attract capital and help narrow the current account gap.
The pound may have to fall further, he thinks, but its reversal is likely to be a ‘natural balancing process’ rather than a spiral or crisis.
That seems like a pretty favorable picture of the week’s turmoil. Others think these rumblings reflect persistent inflation and weak growth in Britain, exacerbated by recent employment tax increases. Some worry that a sharp period of sterling weakness could irritate inflation again and further tie the BoE’s hands.
Be that as it may, it appears that the British pound’s time in the sun is over for now. But this fall from grace could be what is needed to solve the problem and draw foreign investors back to higher-yielding government bonds.
The opinions expressed here are those of the author, a columnist for Reuters.
(by Mike Dolan; editing by Sonali Paul)
