UK market sell-off slams gilts, pound, piling pressure on BOE

UK market sell-off slams gilts, pound, piling pressure on BOE
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LONDON (Sept 26): The sell-off in UK assets went into overdrive on Monday, sending the pound to an all-time low, slamming government bonds, and sparking talk of emergency action by the Bank of England (BOE).

The market mayhem extended the damage seen on Friday in the wake of the government's new fiscal measures, which sent investors into a panic. The plunge in UK gilts sent 10-year yields above 4% for the first time since 2010. Sterling dropped to as low as US$1.0350, taking it closer to parity with the dollar, although it subsequently pared its loss to US$1.08.

The latest tumble — fuelled by Chancellor Kwasi Kwarteng's comment on Sunday that there was "more to come" on tax cuts — prompted calls for aggressive rate hikes from the BOE, with some urging emergency action as soon as this week.

It has also led to talk of a currency crisis and is threatening to engulf Prime Minister Liz Truss' days-old administration in turmoil as the country grapples with a cost-of-living crisis and a recession.

Sky News reported that the BOE is expected to make a statement on Monday. A central bank spokesperson earlier declined to comment on the market moves.

"The market remains very fragile and with the moves being driven by emotion it is very difficult to trade intraday," said Antony Foster, head of G10 spot trading in EMEA at Nomura International plc. "Parity for cable feels like a matter of time and while vols are off their highs there is no sense of relief in the price action this morning."

Traders have ramped up bets on BOE rate increases, pricing in 200 basis points (bps) of tightening by the next policy meeting in November. They see the key rate peaking at 6.25% by November 2023. Some forwards markets have even priced in a hike on Monday.

At Bloomberg Economics, economist Dan Hanson said currency's drop "will set alarm bells ringing at the central bank". If it is sustained, he sees the BOE raising its benchmark by 100 bps.

The BOE previously tried to prop up the pound on Black Wednesday, using rate hikes and currency purchases when sterling crashed out of the Exchange Rate Mechanism, a system linking a number of European currencies. That defence, which took place 30 years ago this month, ultimately failed.

"We think that the BOE is too psychologically scarred from the events of 1992 to try defensive currency-related rate hikes," said Chris Turner at ING. "What happens if the BOE hikes 300-500 basis points and [pound/US dollar] ends up trading lower?"

Another option is direct currency intervention, but it does not have enough reserves for a meaningful, sustained action. One possible response to the bond market moves is for the BOE to delay a planned sale of the gilts it bought under quantitative easing. That process is due to begin next week.

On Monday, 10-year yields rose 28 bps to 4.11%, and the five-year yeilds jumped 47 bps to 4.55%. 

Domestic-focused UK stocks including homebuilders, retailers, and banks also slumped. The FTSE 250 index fell 1.4% as of 1.50pm local time, extending a year-to-date plunge to 25%.

Sterling's early-hours slump marked its biggest intraday drop since March 2020, when the Covid-19 outbreak roiled markets worldwide. A CME Group spokesperson confirmed that the dramatic fall triggered a two-minute pause in trading of front-month British pound futures contracts at 2.01am UK time, after a circuit breaker kicked in.

Options markets see a near-50% chance of the pound reaching dollar parity this year, up from 32% on Friday. Truss would face a rebellion from Tory backbenchers against her tax cuts if the pound hit that level, the Telegraph reported on Saturday.

"It would be foolish to rule out parity," said Dean Turner, UK economist at UBS Private Banking. "If the market's got the bit between its teeth, then fair value, or valuations or fundamentals are going to count for very little."

Gerard Lyons, an external adviser to Truss, acknowledged on Monday that the market has concerns about government policy. But he said that while Kwarteng should reassure investors, he should not reverse course.

"He needs to reaffirm that tax cuts are only part of the story, not the full story," Lyons said on Bloomberg Radio. "What they're following is a supply-side agenda."