This time it’s different

Back in late September 2022, the then Chancellor Kwasi Kwarteng delivered a growth plan now often referred to as the mini-budget. The first major policy announcement of the Liz Truss government, the plan was aimed at boosting growth through a series of tax cuts and other similarly supportive measures. Financial markets didn’t react well to the mini budget, announced at a time of 10% inflation, it was feared that these measures would likely stoke the price flames further.

Additionally, and more importantly, there was concern over the lack of detail around how the government would pay for the tax revenue reductions, and it became clear the plan was through increasing the national debt as opposed to finding savings in other places which caused investors concern. For those that follow financial markets, or just any person living in the UK that walked near a TV or newspaper in the aftermath, you will recall the sharp drop in the pound and rise in the UK yield curve from a sizable premia investors applied to UK debt. The mortgage market in particular became a hot topic as a result.

At the start of September 2022, the pound was trading at around 1.15 against the US Dollar and 1.16 against the Euro in GBPEUR terms, while 2 year UK Gilt yields were at an already elevated 3% from fast rising inflation. By the end of September, the Pound traded as low as 1.0350 against the US Dollar, 1.08 against the Euro, and 2 year UK Gilt yields had peaked around 4.7%. We all know how this ended, a new Prime Minister and Chancellor in the weeks that followed, a reversal of almost all the announced plans from the mini budget, and in fact a plan to tighten the UK belt even further to gain some calm and credibility from international investors. In the weeks that followed, the Pound returned to 1.15 against the US Dollar and Euro, and 2 year UK Gilt yields returned to 3%.

Fast forward to June 2023. Almost all measures from the mini budget never came into effect. Inflation has finally fallen below the 10% mark as the sharp external effects on prices from the Russia Ukraine conflict start to roll out of the annual numbers (annual inflation in June will be comparing against the already elevated price levels of June 2022). A stubbornly long period of inflation above 10% in the UK and tight labour market conditions has led to a strengthening in wage inflation, the latest figures for April seeing pay growth of 6.5%, transitioning inflationary pressures from external supply shock factors into stickier demand factors. In response the Bank of England has continued to steadily raise interest rates in the UK to dampen this demand, with UK 2 year UK Gilt yields trading above the September 2022 highs of 4.7% for the first time since. But the Pound isn’t back to 1.0350 and 1.08 against the US dollar and Euro respectively, why?

To borrow a phrase that many in financial markets are saying at the moment, this time it’s different. While the continued move higher in UK rates has reached similar heights to the September 2022 peak, that is where the similarity ends. This rally in UK yields is not from a premia demanded by investors from perceived risks, it is driven by genuine higher rate expectations and that is Sterling supportive. Government policy planning is not creating uncertainty or adding to elevated inflationary pressures so we are not seeing a flight from the Pound. At the time of writing the Pound is trading at 1.28 against the US Dollar, much stronger than in September 2022 as the FOMC moved to holding interest rates in June after 10 straight increases, and there is scope for a further move higher in the pair if policy expectations continue to diverge. The Pound is back around 1.17 against the Euro in GBPEUR terms, but with the UK still at risk of a recession later this year, and there being less potential pressure on the ECB to reduce rates as quickly as the BoE and the Fed in 2024, it may be difficult for the Pound to gain further traction against the single currency in the medium term.

Disclaimer: All information is sourced from Bloomberg