UK financial markets are in “turmoil”. This somewhat CNBC-esque opening, however, covers it well. And it has resulted in a chart that usually belongs to an emerging economy on the verge of collapse. The British pound is falling despite rapidly rising interest rates.
Normally, the reverse is true, as short-term interest rates are one of the most important factors for currency movements. The chart also shows that the Bank of England’s unorthodox intervention on Wednesday has not yet done much for the pound.
The extreme rate movements in UK markets are the direct result of brand-new finance minister Kwarteng’s plans to cut taxes (especially for the highest earners). But few thanked him for doing so.
With UK inflation expected to bivouac above 10 per cent for months to come, the last thing the Bank of England is waiting for is a mega-bailout package to ease UK consumers. This actually further increases the likelihood of structurally higher inflation expectations. Meanwhile, the IMF has also thrown in its lot and given the UK a hefty reprimand - as if it were an up-and-coming country.
Opposites
So markets are not keen on the new fiscal plans either. Debt levels are rising further and many investors have little appetite to get on that rollercoaster. Moreover, the situation now arises that the Bank of England must intervene to ‘undo’ the impact of the new stimulus measures on inflation. The bank has to raise interest rates more aggressively, resulting in negative effects on economic growth. This in turn reduces the impact of the stimulus measures, and so on.
We now see exactly the opposite happening as during the Covid crisis. Instead of central banks and governments reinforcing each other, they are now directly working against each other.
Reserves
Another way to break the spiral of higher interest rates and a lower pound is currency intervention. Last week, the Bank of Japan actively stepped into the market to come to the rescue of the ever-declining yen. However, for the Bank of England, this is not an option. The bank has zero ‘firing power’ to support the pound.
The UK central bank has $108 billion in foreign exchange reserves, barely 3 per cent of UK GDP. By comparison, Japan has $1180 billion at the ready, equivalent to 28 per cent of Japan’s GDP. And Switzerland - which inherently must have large reserves to maintain its loose peg to the euro - has $800 billion in reserves on its books, more than 100 per cent of Swiss GDP.
Conclusion
So, for the Bank of England, there is little choice but to raise short-term interest rates - and raise them more than other central banks - and then hope that historical relations recover. Buying up long-term bonds to keep long-term rates from rising too much, which is obviously no fun for the already sagging UK mortgage market, cannot go on for too long. Before you know it, it is called “quantitative easing” and you are left with an even bigger inflation problem.
Jeroen Blokland is founder of True Insights, a platform that provides independent research to build diversified multi-asset portfolios. Blokland was most recently head of multi-assets at Robeco. His chart of the week usually appears every Monday on Investment Officer Luxembourg.