It is worth understanding the three main forces in financial markets: economic fundamentals, technical trading, and sentiment. At the beginning of last week all three of these aligned to send the pound briefly to historic lows.
Economic fundamentals, which tend to drive long term trends, have been weak for the pound, partly driven by aggressive monetary tightening in the US and a flight to safety, but also because the UK economy is seen as the weakest and riskiest of the world’s major economies. What the market calls “technicals” is really about the active trading positions being taken at any specific point in time. Traders and speculators were taking large short positions and bets against the pound so the technicals for the pound were also weak. Tying these together is sentiment, and sentiment has a huge influence on short term and long term volatility and market movement.
The mini budget did not greatly change the fundamentals for the UK markets. What we have seen over the past week is a shift in market sentiment towards the UK economy.
This sentiment is not necessarily about UK government borrowing. The announcement on energy price caps, which will lead to somewhere between £70bn and £150bn of additional UK government borrowing, did not significantly move the markets, because sentiment was largely positive.
The recent moves are because the markets have lost confidence in the Bank of England and Government working together to manage inflation and interest rates in a way that minimises the impact on overall economic activity. The sentiment is all about inflation and interest rates.
It was a combination of the Bank of England not raising rates as far as expected and the potential inflationary impacts of the mini budget that shifted market sentiment.
The markets are now taking a view that either inflation will be sustained and prolonged in the UK, or interest rates will have to rise to a point where they push the UK into a severe recession. The markets are looking for co-ordinated fiscal and monetary policy response to counter inflation and are not seeing it. Expect a lot of volatility on any announcements impacting sentiment and continued weakness unless the markets see a significant change in interest rate and inflation expectations.
Note: Markets are coming back this week as they now believe the government realises it will have to take a monetary and fiscal tightening approach to inflation (i.e. raising rates, cutting government spending and not reducing taxes). Dollar weakening on the back of China selling USD has also helped all currencies.
Bank of England Between a Rock and a Hard Place?
The easiest way for the Bank of England to restore confidence would be to come out and match US interest rate rises. The problem is that the US economy is not as exposed to interest rate rises as the UK economy. Mortgages in the US are fixed rate. This means that even when interest rates were low, US mortgage rates were around 7% compared to 2% in the UK. However, rising rates in the US only impacts new mortgages, not existing mortgages. In the UK, the economy is massively exposed to interest rate rises because most mortgage rates are only fixed for 2 years. This puts the Bank of England in an almost impossible position, needing to match US rate rises because of the currency exposure, but unable to do so without crashing the economy. In the UK we are much more dependent on a co-ordinated policy, fiscal and monetary response to counter inflation because we can’t just rely on rate rises. This is what the market wants to see.