Alright, before we start I know what you’re going to say. Where’s the piece on the Bank of Japan?

The plan was to deliver that piece yesterday but after an eventful Friday evening and start to the week for the pound, something we haven’t seen in over 50 years, I had to make an exception! BoJ piece will be released on Friday, look out for it.

Now, back to it:

Is It The “Mini-Budget” Or Uk’s Macro Climate?

This is the question on most investors’ and traders’ minds. What is the root cause of this crash in the pound?

Now, if you’ve been living under a rock the past few days, let me quickly recap what has been going on within the Uk.

On Friday 23rd September Kwasi Kwarteng, Britain’s new Chancellor announced his growth plan, which consists of the biggest tax cut in 50 years. The last time the Uk saw a tax cut of such significant size we were in the 1970s inflation period, where the annual inflation rate averaged 12% on a calendar year basis. An inflation figure we will most likely see this fall if economic conditions continue in their current trajectory.

Now, the markets’ reaction to this “mini-budget” was nothing short of dreadful. Immediately after the plans were announced there was an immediate withdrawal of capital from the Uk. Earlier this week, the pound touched as low as $1.03, and gilts also took historical losses as investors weighed away from any assets associated with the Uk; the factor being investors believing that the new growth plan will only add fuel to the inflation fire, which is currently sitting at 9.9%. Not only are investors weighing on the risk of further elevated inflation figures but also the new ‘mini-budget is set to push borrowing to unsustainable levels.

Chart 1: Cable Rates

Chart 1 shows the market’s verdict on the government’s fiscal plans, and it’s not a positive one at all. During the trading hours on Monday Andrew Bailey, Governor of the Bank of England delivered a statement that many believed was going to be an emergency rate hike to prop up the pound, however, Bailey shut down all bets that we would see an emergency rate hike saying:

“it will make a full assessment at its next scheduled meeting of the impact on demand and inflation from the Government’s announcements, and the fall in sterling, and act accordingly. The MPC will not hesitate to change interest rates by as much as needed to return inflation to the 2% target sustainably in the medium term, in line with its remit.”

— Gov Bailey

Feel like I’m watching Jay Powell’s ‘transitory’ speech all over again…

Gilts losses, Government Deficits and Quantitative Tightening

If you’re still scratching your head trying to figure out whether this destruction in UK markets is because of the mini-budget or the current macro picture let me put your mind to rest.

All that has happened since Friday is a massive acceleration in the downwards direction of where the Uk’s economy was already headed.

Let me explain.

Chart 2: Underlying government debt forecast as a percentage of national income (23 September 2022)

Prior to the mini-budget, the Office for Budget Responsibility (OBR) forecasted that borrowing would be on a steady decline from 2024 onwards; dropping from roughly 84% of national income to just above 80%, a mere 3-4%. After the mini-budget, we can now expect that number to rise an astounding 10% to 94% of national income.

Keep the above chart in mind.

Chart 3: Uk Bond Market Overview

Now, when looking at data what’s most important isn’t so much the current data point we are seeing, in this case, the yield, it’s the rate of change over a period of time which tells us more about how an economy is shaping up. The chart below will realise this for you.

Chart 4: UK Gilts Yield

This should set in stone what is happening within the Uk. Just over a month ago, 10y-gilts (government bonds) were yielding just over 2.61% on an annual basis, rewind six months back and you were receiving only 1.68% on an annual basis. Now, 10y-gilts are yielding up to 4.7%!

You may be thinking, what effect will this have on the economy?

  1. The cost of capital is sky high, levels which make it undesirable for businesses to borrow funds and pursue new endeavours.

  2. If the Uk government is funding the EPG, (Energy Price Guarantee) & mini-budget with debt then with the current cost of borrowing topping 4.5% for longer maturities the government will be paying sustainably higher interest payments on debt enlarging the deficit.

  3. With the Bank of England's confirmation to reduce its balance sheet holdings of Gilts by £80bn over 12 months, the government taking on more borrowing (issuance of new debt) only adds fear and uncertainty to the broader markets across the Uk. Hence the massive sell-off we have seen within the Uk debt market.

In essence, the realisation that the supply of debt that will have to be sold by the government outweighs the current demand within the market is what has led markets to plunge. This causes investors to flee Uk debt markets and the currency as a whole.

Ray Dalio said it best:

“It suggests incompetence. Mechanistically, the UK government is operating like the government of an emerging country; it is producing too much debt in a currency that there is not a big world demand for.”

— Ray Dalio, Founder of Bridgewater Associates

As it stands sterling has gained some upside pulling back into the $1.07 mark against the dollar; with the current array of factors at hand within the Uk it is hard to see the pound moving any higher than it is right now. Short bets are looming over the currency with hedge funds applying pressure to benefit from the demise.

Sterling Rates As of 27th September '22

Such an event only makes the dollar even more of an attractive alternative and investment to the pound, equities, crypto/ alt investment.

Dollar UUP ETF Index Performance

In the past month alone the dollar ETF is up 5.25%! This has more to do with key commodities/assets being priced in dollars, so the repatriation of assets/currency results in dollar demand rather than the actual economic condition of the U.S.

At the end of the day, the saying remains,

dollar is King!

Hey, thanks for reading all the way until the end, I appreciate each one of you guys/girls — we’re experiencing some serious growth within the MMH community so expect some exciting things ahead from me to you!

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Until next time,