A sell-off in the pound and UK government bonds, known as gilts, has pushed both to multi-year lows as investors grow increasingly nervous about the country’s economy.
With selling accelerating on Wednesday morning, August moved from being a painful month for both the pound and gilts to appalling, which is expected to cause further headaches for the government and potentially prolonging pain for London's equities.
The pound fell below US$1.161 on Wednesday afternoon, scraping levels last seen amid the early weeks of the Covid pandemic and before that in 1985, while short-term gilt yields hit highs not seen since 2008.
Sterling has dropped 4.5% against the dollar in August, its worst month since 2016’s Brexit vote, sliding from $1.225 to below $1.161 today
Alarm at the economic outlook and political uncertainty led to bond investors also selling up, extending August’s gilt exodus after the Bank of England’s big hike early in the month and new highs for inflation.
“This is one of those ultimate meltdowns," Marc Ostwald, economist and market strategist at ADM Investor Services, told Reuters, comparing it to the 'bond market massacre' of 1994 that was triggered when interest rates were hiked off what had been low levels.
“The summer break hasn't been kind to gilts,” said UBS, also noting the surge in gas prices and forecasts for the Bank of England’s peak interest rates climbing to around 4%.
Increased prospects of fiscal stimulus have, said UBS, “created a perfect storm resulting in gilts significantly underperforming on a cross-market basis and the cash curve bear-flattening”.
UK 20-year Glit yield to >3.2%, a fresh high since 2014, up 11 bps today.???????? $GBP pic.twitter.com/bIY77AkQ9v
— CN Wire (@Sino_Market) August 31, 2022
The pound and euro are likely to plumb even further depths, predicted Paul Dales, chief UK economist at Capital Economics, as the energy crisis pushes both the eurozone and UK economies into recession.
Meanwhile, he expects the US will get away with a milder slowdown, suggesting that the euro and the pound will weaken further against the US dollar.
He forecasts the pound will fall to an "all-time record low" of around US$1.05 by the middle of next year, along with a "big decline" in the FTSE 100.
UBS said it expected 10y gilts to fall reach 3%-3.25% as hawkishness from central bankers continues reverberating through the gilt curve and expected cost-of-living support measures from the new UK Prime Minister drive near-term inflation.
“The key risk we see here is that broad-based (rather than targeted and measured) fiscal measures aggravate the already elevated inflation pressures and trigger an even stronger monetary policy response," said UBS strategist Rohan Khanna.
“We expect such an unfriendly fiscal monetary mix would set the alarm bells ringing for gilt market participants and trigger further cross-market underperformance.”
With the BoE turning an active seller of gilts, with its portfolio expected to shrink by around £80bn in the next 12 months and remain an active seller for the next few years.
As bond yields bottomed out in mid-2020 and have since surged higher, demand for gilts from insurance companies and pension funds in the UK has waned, UBS noted, which has put “all the onus on non-residents”, who have been the only other net buyers of gilts since the start of the pandemic – apart from the BoE.
“With all the UK's macro challenges – twin deficits, double-digit inflation, more policy tightening, increased issuance – for how much longer gilts will continue to find succor from non-residents is an open question,” Khanna said.