A tumultuous week in all things sterling

There has been much reporting about the “not so mini” budget delivered by U.K. Chancellor Kwasi Kwarteng last Friday and the response from financial markets. Asian markets exacerbated the initial reaction from Friday 23 September when they opened Sunday night U.K. time. By then, they had the opportunity to digest the full media response (overwhelmingly negative) and reflect that in the currency markets — with GBP hitting an all-time low of 1.03 against USD.

There have been calls all week for new prime minister Liz Truss and Kwarteng to U-turn on their unfunded tax cuts, and rumours circulated of the Bank of England (BoE) stepping in with an unscheduled interest rate rise — neither of which materialised. Standing back from the initial surprise of the announcement, and unpicking the financial implications, it's hard to understand why the markets reacted so violently.

The corporation tax and the National Insurance (NI) reversal were reported widely prior to Kwarteng’s “fiscal event”, as was support for energy bills (the largest part of the fiscal package). Consequently, the only “new” news was the income tax changes. Since the cut in the top rate of income tax is a tiny cost in the overall giveaway, and assuming it has zero further benefit to the economy in terms of incentives, etc., it is hard to believe that the overall cuts which amount to less than 0.25% of GDP would cause a sterling crisis.

What was the real message from the markets? The continuation of the theme that the BoE has lagged in its response to stemming inflation and has been too slow in raising U.K. interest rates. The Fed has raised U.S. interest rates 75 bps twice in a row, and with the U.K. arguably facing a larger inflation challenge, the BoE’s 50 bps increase was not enough to quell fears that inflation will remain higher for longer.

The intervention by the BoE in the gilt market to stabilise rates (and this will continue until 14 October) was for very specific technical reasons around the U.K. pension funds, and their exposure to higher interest rates. This has meant that these funds have had to post significant collateral against their liability hedges, causing a large liquidity issue. This is not a restart of quantitative easing, but a temporary action to restore orderly market conditions. However, there will be a short delay in (quantitative tightening) gilt sales to 31 October (originally slated to begin on 6 October).

Taking the movement in GBP currency and U.K. interest rates, one might conclude that the market is signalling that U.K. rates must rise more than indicated by the BoE. Whether they will reach levels close to 6% remains to be seen. It is difficult to see this occurring without triggering a very severe recession. The speed of the upward adjustment will cause huge challenges to the economy — particularly in looking at the volume of fixed-rate mortgages to be refinanced in the coming year. These will be at rates 500 bps higher than current fixes, leading to a large increase in mortgage servicing costs and a material drag on household expenditure.

In practical terms for our clients, the market was effectively closed on 26 September, and execution of hedging in GBP was close to impossible. Traders could not quote prices, and they were not willing to expose themselves given the volatility. Some borrowers, if they can, are adopting a short-term wait and see before putting their hedges in place. For many borrowers, interest rates are now so substantially above their modelled base case, that entering a fixed-rate here would immediately challenge their covenants. There are some solutions: paying large cash premiums at the outset to reduce ongoing interest servicing is being deployed by those who have the liquidity to do that. Across the corporate and commercial sector (not personal, residential mortgages referred to above), early anecdotal evidence is emerging of banks realigning lending parameters to reflect increasing projected debt servicing costs on interest cover (ICR). A credit position that would be exacerbated by reductions in asset values (LTV).

When sentiment, rather than rationality, is driving market movements, it is a difficult decision to pull the trigger on putting hedging in place. However, news indicates that higher interest rates likely will continue longer than the market initially anticipated. The adjustment to normal interest rates is truly underway.

Chatham leverages our technology and focuses on helping our clients hedge their interest rate and foreign current risk in many ways. To follow the developments of the market's expectations of forward interest rates visit Chatham Rates or get in touch with one of our advisors using the form below.