UK Gilts and Pound Plummet Amid Fears Over Unsustainable Deficit

Debt and the UK's Achilles' Heel

Following our discussion yesterday on the UK's newly announced budget, we highlighted that debt has always been the UK's Achilles' heel. The country lacks the privilege of having the world's reserve currency, unlike the US, and can only print a currency that is becoming less desirable. This could lead to long-term inflation, which is why the market is reacting as it is.

Market Reactions and Potential Emergency QE Action

Markets are waking up to the reality that UK rates may not fall as much as previously anticipated, or as much as the Bank of England (BOE) would like. If the surge in yields continues, we might be on the brink of another emergency quantitative easing (QE) action by the BOE. This would be the second such action in two years, reminding the world that the US's ability to borrow excessively is due to its status as the world's reserve currency. However, recent surges in gold and bitcoin suggest this may not last.

Gilt Yields and GBPUSD Sell-Off

Today, we see confirmation of our predictions as both 2Y and 10Y Gilt yields are surging, and the GBPUSD is experiencing a sharp sell-off. The entire gilt curve is flattening, with the 10Y trading at its highest level since October 2023 and the 2Y returning to May levels. "It looks like a VaR shock to me," warns UBS trader Leo He, noting that the US 2y yield is following the sharp rise in the UK 2 yield.

Understanding the Fiscal Easing

DB's Jim Reid agrees with our perspective, suggesting that the market is finally realizing the true extent of the fiscal easing. The UK Debt Management Office's revised gross financing needs are approximately £146bn, twice what DB expected between 2025-2029. As DB's economist Sanjay Raja noted, "today's budget marks one of the largest fiscal loosening of any fiscal event in decades".

Comparing Budgets and Market Reactions

It is interesting to note that 10yr Gilts are now only 10bps lower than the closing peak two business days after the ill-fated "mini-budget" under PM Liz Truss in September 2022. In terms of comparing the two budgets, in 2022 there were £45bn of unfunded tax giveaways, whereas the most recent one had £32bn of unfunded commitments. The credibility of the recent budget is arguably enhanced by around one-third of increased government spending being targeted for investment in the economy rather than the tax cuts of two years ago.

Putting Things in Perspective

Looking ahead, the UK budget deficit between 2025 and 2029 is expected to average around 2.5% of GDP. In contrast, in the US, it could be 7-9% without offsetting measures to the campaign promises of the two candidates. This, Reid echoes our note from yesterday, "helps highlight the exorbitant privilege of the US in having the world's reserve currency."

Concerns Over Smaller Deficits

Other countries with smaller deficits are starting to reach debt and deficit levels that are raising eyebrows in the markets. The ongoing French budget issues are another example of this.

Bottom Line

In conclusion, the recent budget was probably two-thirds of the Truss mini-budget in terms of fiscal easing. However, the bulk of the higher borrowing is due to more investment, albeit ones that aren't expected to bear fruit in growth terms until after the 5yr time horizon. What are your thoughts on this matter? Do you agree with the market's reaction to the UK's budget announcement? Share your thoughts and this article with your friends. Remember, you can sign up for the Daily Briefing, which is available every day at 6 pm.