UK Financial Markets and the Pound

By Mike Dolan

LONDON (Reuters) – The pound is once again under pressure as UK financial markets show signs of instability, indicating stress in a nation reliant on foreign financing. However, this situation may also serve as a safety valve to address existing issues.

An alarming spike in British government bond yields at the start of the year is largely attributed to a significant rise in global sovereign borrowing costs, particularly due to a surge in U.S. Treasury yields ahead of Donald Trump’s incoming administration.

Despite these challenges, the gaps between British gilt yields and U.S. 10- and 30-year bonds have remained relatively stable over the past three months. Nevertheless, this week, nominal 30-year gilt yields reached their highest level in over 25 years, while 10-year yields went back to 2008 levels. This poses challenges for the new Labour government, which is struggling to implement its pro-growth agenda while dealing with the unfavorable reception of its tax-and-spend budget from October.

In an unexpected turn, the pound no longer followed gilt yields higher this week, as it had done for most of the past year, and instead moved in the opposite direction. Just a month ago, the pound attained its highest value against the euro since 2016 and similarly set records on a broader trade-weighed index in November.

This sudden shift recalls the budget crisis under former Conservative Prime Minister Liz Truss. Interestingly, no major changes have occurred in the UK’s domestic economy recently to justify this turnaround, even amidst reports of Elon Musk, a billionaire Trump advisor, aiming to oust the UK Prime Minister.

Previously, many market participants were building sterling positions, encouraged by the Bank of England’s relatively tight monetary policy compared to the rest of Europe and confidence in the UK’s capability to endure a Trump-inflicted global trade war.

However, many of these positions are now swiftly being reversed, driven by the belief that British borrowing costs cannot continually rise alongside U.S. Treasury yields without causing significant economic and budget pressures in the UK, which has less capacity to absorb such challenges than the U.S.

Is This a Crisis?

There are no current signs of widespread debt market disruptions similar to those observed in 2022. Although implied pound volatility has increased, it remains significantly lower than in previous crises. Should problems arise from global markets rather than domestically, the UK government may have less ability to address them.

The combination of a weakening pound and rising gilt yields serves as a warning. Some analysts view this as an ongoing issue, worsened by the UK’s exit from the European Union and its relatively small, open economy, which is more susceptible to changes in global financial conditions.

Deutsche Bank’s top currency strategist, George Saravelos, cited the UK’s longstanding balance of payments deficit as a critical factor. He emphasized that heavy reliance on foreign financing for debt issuance makes the UK particularly vulnerable to global market dynamics.

The recommended solution, according to Saravelos, is a weaker currency, which could attract foreign investment by making UK assets cheaper. Although the pound may decline further, he anticipates that this will be a normal equilibration process rather than a direct crisis.

While some view the recent market fluctuations as benign, others consider them indicative of persistent inflation and weak growth. Concerns remain that a steep decline in sterling might exacerbate inflation and further restrict the Bank of England’s monetary policy options.

Regardless, the pound’s uptrend appears to have come to an end. This decline may ultimately be necessary to rectify current issues and lure foreign investors back to higher-yielding gilts.

The views expressed in this article are those of the author.