Investors and analysts expect sterling and UK government bond prices to weaken further as the country issues billions of pounds of debt to finance Prime Minister Liz Truss’ new energy package.
Under the plans announced on Thursday, the government will spend around £150 billion to reduce energy costs to £2,500 per household over two years. The government has not said how the package will be financed, but investors expect it will borrow money from bond markets. Along with some other fiscal measures, this could mean up to £250 billion in extra gold issuance from 2022 to 2024, Barclays forecast.
The program is designed to help the finances of households across the country. But it could also complicate the longer-term picture for inflation and will require significant new buying interest in UK debt.
“Retail investors will have to absorb the extra gold that needs to be issued,” said Stefan Koopman, senior macro strategist at Rabobank. “Trush may believe in the markets, but the markets don’t have to believe in Truss.”
A big increase in spending would come at a time when the UK is already relying more on foreign funding to prop up the economy. The current account deficit hit £51.7bn — or 8.3 per cent of gross domestic product — in the first three months of this year, the highest on record, according to the Office for National Statistics.
Long-term UK government bonds are already under pressure. As prices have fallen, 10-year gold yields have jumped at the fastest pace in two decades, Barclays noted, reaching nearly 3.1 percent. In early August, it was below 2 percent. Bond yields rise as bond prices fall.
The pound fell 5 percent against the dollar in August, its biggest monthly drop since the Brexit referendum, and is down 14.4 percent this year to $1.16. Much of this is due to a sweeping rally in the dollar, but the pound’s decline has outpaced that of the euro this year.
The additional government largesse required to mitigate the energy crisis could exacerbate these trends.
The £250bn borrowing estimate “represents an extreme scenario”, said Moyeen Islam, interest rate analyst at Barclays. But “simply put, the gold market would struggle to absorb monthly sales of around £33bn without a significant repricing of yields and spreads.” That means lower bond prices and higher borrowing costs, especially as they will come at the same time as the Bank of England plans to start quantitative tightening – trimming the portfolio of bonds it bought to prop up the economy after Covid hit.
“In 2020-21, net pocket supply averaged around £20bn per quarter after taking into account BoE purchases,” Islam said. “Under [this new] scenario. . . the market will be called upon to absorb £75-100bn per quarter.’
The energy package will remove the “sharpest edges from inflation” for now, reducing inflation by almost 5 percentage points by the end of 2022 as pressure eases on household energy bills, Koopman told Rabobank. This brings some benefits, but also suggests that rate hikes could be slower.
“Less cumulative tightening than there is today, combined with increased economic and political risks, will lead to an underperformance of the pound,” said Paul Hollingsworth, chief European economist at BNP Paribas.
The BoE continues to expect the UK to slip into recession, further weakening the pound. Vasilios Gionakis, head of European FX strategy at Citi, expects it to dip into the $1.05 to $1.10 range.
“I’m really bullish on the outlook for sterling,” he said. “It all boils down to growth: interest rates are good for the currency when they happen to tame very strong demand and put downward pressure on inflation. Hiking into recession is not good for the currency.”