(Bloomberg) -- A hectic week for UK bond and currency traders came to an end with yields stuck near the highest levels in years and the pound at its weakest since late 2023.
Gilts and sterling fell again on Friday after a surprisingly strong US job report. Though the latest moves were in line with peers, they came on top of a brutal selloff in UK assets, which left long-term borrowing costs at levels last seen in 1998.
Concerns over the state of the UK’s stretched public finances combined with persistent inflation fueled a sharp market rout this week, and drew comparisons with a market meltdown two years ago that toppled Liz Truss’ administration.
Yields on 10- and 30-year gilts jumped about 25 basis points in five sessions, the most in a year. While many investors say the selloff was overdone, caution prevails ahead of a key UK inflation report next week.
“More clarity around fiscal policy at the upcoming budget, and about the evolution of the bank rate might be needed for gilt demand to return in a sustainable way,” Morgan Stanley strategist Fabio Bassanin wrote in a note. “Given these prevailing dynamics we recommend investors maintain a cautious stance on UK rates.”
Fidelity, Pimco Stick With UK Gilt Bets After Market Turmoil
UK officials have tried to reassure markets. Darren Jones, the Treasury’s chief secretary, said the gilt market is functioning in an “orderly way,” comments that were later echoed by the Bank of England’s Deputy Governor Sarah Breeden, who said she’s willing to continue with further interest rate cuts.
The remarks bode well for big investors including Pacific Investment Management Co., Franklin Templeton and Fidelity International who are sticking to their bullish bets on UK government bonds. Some are even looking to buy more.
But for the Labour government the backdrop remains challenging. Higher borrowing costs threaten to wipe out the dwindling £9.9 billion ($12.2 billion) of fiscal headroom. Chancellor of the Exchequer Rachel Reeves may be forced to tighten fiscal policy, likely favoring fresh cuts to public spending over tax hikes.
Even if markets calm and reverse course, the moves this week mean that threat of a backlash will hang over every fiscal move in future. Investors are doubting Reeves’ plans to deliver the growth needed to tackle the national debt pile, and to address persistent inflation.
“They really need to reconfigure a story quite quickly that calms the market’s understanding of a diminishing headroom on the fiscal” side, said Daniel Loughney, head of fixed income at Mediolanum International Funds Ltd.
The next inflation report on Wednesday will be crucial for gilt investors assessing the risks and the BOE’s next steps. Consumer price growth is expected to have remained unchanged at 2.6% in December from the previous month, according to a Bloomberg survey, above the 2% target.
“The combination of sluggish growth and above-target inflation are adding to investors’ nerves,” Deutsche Bank strategists including Henry Allen and Jim Reid wrote in a note. “And the current pattern of market moves, with yields up and sterling down, is reminiscent of previous episodes of turmoil.”
Investors will also be eyeing a £4 billion sale of 2034 gilts next week for any signs that demand in the primary market is waning.
UK Bond Selloff Puts Reeves’ Economic Project on the Brink
Meanwhile, the outlook for the pound remains bleak. Banks including Wells Fargo and Deutsche Bank AG said there’s room for the currency to drop further as investors unwind long positions and the BOE cuts interest rates.
Options activity suggests traders are bearish on the pound, and there’s been evidence that liquidity in that market became “very stretched” as traders flocked to bet on further losses, according to Optiver.
“The concern is that we’re going to end up having more fiscal austerity to offset the effect of higher payments on gilts, which slows the economy down, which wouldn’t help sterling,” said Kit Juckes, head of global FX strategy at Societe Generale SA, on Bloomberg Radio. “None of that will help.”
--With assistance from Alice Atkins and Naomi Tajitsu.
(Adds details on next week’s bond auction in 13th paragraph.)
