After a bitter three-week battle with the bond markets, UK Prime Minister Liz Truss admitted defeat on Friday. He sacked the finance minister and destroyed his economic program by ordering the reinstatement of a large tax increase on businesses.
Truss said he acted in the national interest to ensure economic stability and “reassure the markets of our fiscal discipline”. But it’s not clear whether Truss has done enough to convince skeptical investors, and Friday’s announcement did nothing to quell speculation that he would keep his job.
The price of 30-year UK government debt, which has been depressed in recent weeks, fell after the press conference. The British pound, on talk of a government rethink in recent days, fell 1% to trade at $1.12.
“What markets want to see is a coherent picture of how it all fits together,” said Charlie Bean, a former deputy governor of the Bank of England. “Absent that, you’ll see sterling and the keys come under pressure again.”
Investors rejected the Truss government’s announcement at the end of September that it would cut taxes in a bid to boost growth while boosting lending, on fears the plan would push up inflation, just as the Bank of England wants to reduce. Fears also arose about the sustainability of government debt at a time when interest rates were rising rapidly.
The pound was the lowest against the US dollar as bond prices fell, while yields rose. This pushed mortgage rates much higher, and drove some pension funds into default.
The Bank of England was forced to announce three separate interventions to prevent a full-scale meltdown in the UK government bond market.
Truss said Friday, amplifying that By raising Britain’s corporate tax rate from 19% to 25%, the country would raise £18 trillion ($20 trillion), which he said would be “a complete medium-term fiscal plan”.
But the UK’s credibility will not be so easily revived.
“The government’s growth agenda is in jeopardy,” former Chancellor of the Exchequer Philip Hammond told the BBC. “I’m afraid to say that we’ve put years and years of hard work into building and maintaining a reputation as a fiscally disciplined and competent party in government.”
The market was not guaranteed. Indeed, investors continued to openly speculate whether Truss could continue in his role even after Jeremy Hunt took over as Chancellor of the Exchequer.
“Markets are crying out for more to be done to restore confidence in the UK government,” Paul Dales, chief UK economist at Capital Economics, said on a call with clients. “Removing the truss, I think, would be one way to do that.”
Truss has said he is serious about limiting UK government debt as a proportion of economic activity, but the numbers don’t add up. The new tax cuts leave around 25 billion pounds ($28 billion) at stake, on top of the high cost of winter energy subsidies. A stabilization of the debt-to-GDP ratio by 2024-2025 is still out of reach, according to Capital Economics.
This puts investors on edge, especially as further details on the revised Truss plan are not expected until October 31. Bean believes that date, which was already advanced, should be moved back.
“As for the markets, they want to see a significant change in direction,” he said.
The government said on Friday that Hunt was sticking to his predecessor’s Halloween schedule.
Bryn Jones, head of fixed income at Rathbones, said his team had bought longer-dated UK government bonds this week. They benefited when prices rose, looking for a U-turn. On Friday, however, they sold those shares, with the option of taking the profits.
“Buy the rumor, sell the fact,” Jones said, citing a saying used among investors.
As investors digest the latest developments, government officials and the Bank of England will be on the lookout.
The central bank is on particularly high alert because its bond-buying program of up to £65 billion, which it announced on September 28, ended on Friday. Bank of England Governor Andrew Bailey said earlier this week that it would not be extended.
The central bank had collected nearly £19.3 billion ($21.5 billion) in bonds as of Friday. That is far below what he could have bought. But the willingness to act as a buyer of last resort has served as a salve for the markets, and it is unclear whether it will return once the anxiety recedes.
Global dynamics may also make it harder for UK markets to find their footing, even if the government backs off.
As high inflation persists, leading to uncertainty about how much interest rates will need to rise, many investors are choosing to hold cash instead of debt. The decision to sit on the sidelines is intensifying changes in the bond market at a delicate time.
“I would expect liquidity challenges to persist,” UBS strategist Rohan Khanna said. “I don’t think they’ll go that fast.”
Traders and regulators will monitor how the coming days unfold. So will the politicians, with many whispering that if the situation in the markets does not stabilize soon, Truss may be on loan.