David Lebovitz:                

Hello, my name is David Lebovitz, and I'm a global market strategist at J.P. Morgan Asset Management. Welcome to On the Minds of Investors. This week, I'd like to talk a little bit about the recent action in gilts and sterling. In recent weeks, a series of fiscal and monetary developments led volatility to spike in the United Kingdom's government bond and currency markets. By our lights, the combination of these events amplified uncertainty about the UK's institutional architecture and the Bank of England's commitment to sustainable monetary and fiscal policy. On the monetary front, the Bank of England kicked things off by delivering a 50 basis point hike, which was more tepid than the market expected.

Furthermore, this move came in the wake of more sizable increases by the Federal Reserve and European Central Bank, despite evidence of stickier inflation and limited spare capacity in the UK economy. On the fiscal side, a new government led by Prime Minister Truss took office and made a number of changes to senior civil service posts, including the dismissal of the permanent Secretary to the Treasury. A package capping the energy price and providing a short-term subsidy to confront the energy crisis was delivered alongside a mini budget from Chancellor Kwarteng. This consisted of a reversal of the previous increase in national insurance contributions, reduction in the basic rate of income tax, abolition of the top tax rate, and stamp duty cuts.

Interestingly, no revenue generating measures or spending cuts were announced alongside the tax cuts, and the government provided no analysis of how the new spending plans were compatible with medium-term debt sustainability. The Bank of England finds itself in a difficult position. The government has clearly stated its intent to boost the supply side of the economy. However, in the near term, it will merely add to demand at a time where the UK appears to be running at full capacity with persistently hot inflation. As shown in the chart below, the market expects the Bank of England will need to raise rates by a further 125 basis points in November, and another 75 basis points in December, taking rates to 4.5% by year end.

This will clearly have a dampening effect on economic activity primarily through the housing market, but failure to act with sufficient force risks undermining its commitment to inflation. Despite pressure on the Bank of England to tighten in the coming months, recent market moves have created a more immediate problem. 10-year gilt yields have risen from around 1% at the start of the year to above 4% as markets digest the impact of the fiscal package on monetary policy. With such a sharp move higher in bond yields creating significant disruption, the Bank of England took subsequent action on Wednesday, stating that it would step in and buy long-dated gilts and postpone the start of its quantitative tightening program to October 31st. This led to another leg lower in the British pound, which is now down more than 5% month-to-date against the dollar and down more than 3% month-to-date versus the euro.

Speaker 2:          

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