(Bloomberg) — Markets have turned against the United Kingdom for the second time in less than a year as the inflation and growth outlook darkens for an economy that already lags behind the other G7 nations.
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As the Bank of England struggles to rein in soaring rates, investors have raised bets that interest rates will rise to their highest level in 25 years. The pound has moved further away from those expectations than at any time since Prime Minister Liz Truss’ ill-fated budget rattled the markets in September.
While investors gave credit to her successor Rishi Sunak for stabilizing the situation earlier this year, two important reports in the past month showed wages and prices stubbornly strong – despite the fastest increase in borrowing costs in three decades.
“Markets are questioning the credibility of UK policy,” said Adam Cole, senior currency analyst at RBC Capital Markets. “The gap between prices and the currency is not as wide as it was then, but it is moving in the same direction.”
The next two weeks will be pivotal in shaping the outlook.
On Sunday, Bank of England Governor Andrew Bailey spoke in France and then appeared the next day alongside Chancellor of the Exchequer Jeremy Hunt at Mansion House in London. Official jobs data is released on Tuesday and monthly GDP data on Thursday. Inflation figures for June were released on July 19.
Bailey told the BBC Newsround on Thursday that he “expects a significant reduction in inflation” in the coming months, but that another run-off in wage growth or consumer prices would compound concerns that the Bank of England could be forced to tighten policy excessively and cause a recession.
Policymakers who had been contemplating as recently as March when pressed to halt interest rate hikes quickly shifted toward a more aggressive stance, delivering a surprise half-point hike to 5% last month.
Investors are now betting that the Bank of England will have to raise its benchmark rate above 6.5% to calm inflation, the highest in the G7.
The sudden loss of confidence has renewed talk that the UK is “turning itself into a flood market”, as former US Treasury Secretary Larry Summers put it during the crisis last year. Michael Hartnett, chief investment strategist at Bank of America, said the UK is “the sick man of Europe with stagflation”. “The bet on an unexpected drop in inflation in the near term seems like a triumph of hope over experience,” Cole warned.
Instead of cogs, the Bank of England’s ability to meet its anti-inflation target is now of interest.
“If a bank has credibility, it will be able to resist some – but not all – of the market’s push for higher rates,” said Gerard Lyons, chief economic strategist at NetWealth. “But because the bank lacks credibility, it responds to the markets, not their leadership.”
Negative market sentiment has real consequences. While the pound is the best-performing G-10 currency this year, this week the Treasury paid its highest interest rate for a new bond issue since 2007. Mortgage costs are increasingly unaffordable – a full percentage point above the 5% pain threshold for a bank England is considered a great burden for families. Home prices are falling at their sharpest pace since 2011. Corporate bankruptcies are close to historic highs.
However, the economy is more resilient than expected, Bailey said, with a worker shortage supporting wages. “This keeps the pressure on the Bank of England to raise interest rates further,” said George Buckley, European economist at Nomura.
It is a dramatic retreat from Britain in the year that marks the first anniversary of Boris Johnson’s resignation.
Not so long ago, Britain prided itself on its middle-of-the-road economic model – a bag of image mash-ups from the American free market and European welfare-state policies. Low taxes, low unemployment, flexible labor markets, and universal healthcare. The UK has typically grown faster than its European peers without the social divisions that plague America. Today, it is the world’s cautionary tale.
Italy’s Prime Minister, Giorgia Meloni, plotted a gear-style attack on state institutions until the UK’s budget sent market interest rates soaring in September. In the process, Britain gave the IMF an apt, real-time example of why cutting taxes in an inflationary shock is a bad idea.
Foreign investors vote with their feet. France has overtaken Britain to top the European investment charts compiled by EY since 2019, and the FTSE 100 has been left out of the stock rally that has swept the United States, Europe and Japan this year. Industry gems such as semiconductor maker Arm are listed abroad.
What Bloomberg tells the economy…
“The next batch of UK jobs data will be crucial in determining the Bank of England’s next policy decision in August – another huge 50 basis point hike may still be on the cards. Regardless, the British economy is set to contract in May, as It is possible that the additional national holiday affected the activity.”
—Dan Hanson and Ana Andrade, Bloomberg Economics. Click to get next week.
Business leaders blame the declining narrative on a lack of political vision. Brexit was a negation of the British economic model — an access point to an EU single market with limited labor laws, not a statement of what the UK would be like. This is still not specified.
Sunak wants lower taxes and strong public services but insists tax cuts will only come when the UK can afford them. With rising interest rates adding around £20 billion a year to debt, the Treasury has little, if any, scope for donations.
Meanwhile, Sunak is building an economy very different from the one he is talking about. At least 4 million more Britons have been dragged into income tax since 2020. Corporation tax has risen from 19% to 25%. The overall tax burden in the UK is the highest since the end of the Second World War.
The contradiction between vision and reality speaks of a country in the grip of an identity crisis, and the opposition Labor Party seized the opportunity.
Labor says high rates are a “Tory mortgage bomb”. “There is more than a touch of the Seventies about our economic situation right now,” Labor leader Keir Starmer said Thursday, linking the current malaise to the last time the UK was the “sick man of Europe”.
With elections expected next year approaching, the question of Britain’s growth strategy will come into sharper focus.
— With assistance from Andrew Atkinson, Greg Ritchie, and James Heray.
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