Oct 13, 2022
Bailey’s Gamble Pays Off, For Now, as Kwarteng Rushes Back to UK
(Bloomberg) -- Andrew Bailey was arriving at a meeting in Washington on Thursday as reports filtered out that the British government was preparing what could prove to be the mother of all U-turns.
Asked by reporters whether dropping plans for a massive package of unfunded tax cuts would end weeks of turmoil in UK markets, the Bank of England governor refused to comment but he smiled broadly.
When Chancellor of the Exchequer Kwasi Kwarteng dashed back to London hours later to deal with the mounting crisis, the reason for Bailey’s satisfaction was clear. Friday’s jump in Uk government debt would have delighted him even more as the 10-year yield plunged to below 4%.
Senior UK officials in Washington couldn’t recall the last time a chancellor had left early from the International Monetary Fund’s meeting but it was clear Kwarteng’s budget was unraveling and he had no choice.
Two days earlier, 63-year-old Bailey had found himself in the eye of the storm after vowing to end the Bank’s £65 billion ($74 billion) emergency bond-buying facility this Friday as planned.
Traders had expected an extension and responded by dumping the pound and pushing up the yield on UK government debt. Kwarteng warned that it would be “a matter for the governor” if the rout extended into next week. Analysts predicted that Bailey would be forced to reverse course, suffering a damaging blow to his credibility as a result.
And yet Bailey’s gamble appears to be paying off, at least for the time being.
Markets rallied on the reports of U-turns on corporation tax and other parts of Kwarteng’s so-called mini-budget. The pound closed 2% higher versus the dollar on Thursday, before being little changed Friday. Government borrowing costs, which influence the mortgage costs of UK homeowners, fell as Kwarteng was preparing for a hasty exit from Washington.
“It looks like Bailey’s pressure on the politicians may have worked,” said Tim Graf, head of EMEA macro strategy at State Street. “There is very little chance of purchases being extended.”
For all Kwarteng’s bravado, officials formed a protective barrier around Bailey at the IMF meeting in the US capital, directing blame for the market turmoil squarely at the chancellor and UK Prime Minister Liz Truss. IMF Managing Director Kristalina Georgieva praised the BOE’s bond buying backstop, saying the “action was appropriate” and had addressed “a risk to financial stability.”
Read More: Truss Prepares to Abandon Key Tax Cuts Amid Market Turmoil
She also emphasized the need for “policy coherence and communicating clearly,” a thinly veiled criticism of Truss and Kwarteng’s plan for £45 billion of unfunded tax cuts, announced three weeks ago without oversight of the independent Office for Budget Responsibility, which had unleashed the turmoil in UK markets.
Truss had taken aim at the so-called economic orthodoxy as she campaign for the Tory party leadership over the summer, with support from her longtime ideological ally Kwarteng. They said that conventional, cautious policy-making had held back the UK economy for years.
In Washington, Kwarteng was confronted with many of the leaders of that orthodoxy while Truss was back in London trying to contain the fallout from their own experiment with the British economy.
“The numbers need to add up,” Mark Carney, the former BOE governor, said at a CNN fringe event at the IMF. “In this different risk environment, mistakes will be punished. Yes, institutions matter.”
Bailey’s deadline to scare pension funds into using its emergency facility to close out their positions by giving them a hard deadline also appeared to have worked. On Thursday, the BOE bought a record £4.68 billion of assets. Since the governor’s warning on Tuesday night, bond buying has more than doubled.
The Institute for Fiscal Studies estimates that the government will need to find £60 billion to stabilize the debt. Raising corporation tax as previously planned would save £18 billion. A cut in the aid budget may save another £5 billion.
Senior bankers fear that the bank levy, levied on the balance sheets of the UK’s biggest lenders, may also be increased. One said the government’s growth plan was a good idea, it just needed to be made contingent on bringing the public finances under control first.
What Bloomberg Economics Says...
“Cancelling at least one of the bigger tax giveaways will go someway to restoring market confidence in the UK, but it will take a lot more than that to materially tamp down borrowing costs. There’s another unfortunate reality -- permanent damage to credibility may have been done.”
-- Jamie Rush and Dan Hanson
Click here for more insight
While the market pressure has abated for now, there is still a significant risk that the government fails to deliver the increase in corporation tax or other measures that markets are now pricing in before trading opens next week.
“Some substantive follow through will be necessary if we have any hope of calmer conditions prevailing,” said Richard McGuire a strategist at Rabobank in London.
Following Thursday’s rally in gilts and sterling, and with no BOE bond buying backstop from Monday, investors fear markets may suffer another shock if there are no solid policy announcements on tax and spending.
“The pound will remain under pressure, and I’d be very wary on gilts,” said Stephen Miller, an investment consultant at GSFM, a unit of Canada’s CI Financial Corp. in Sydney. “The optics suggest a chaotic, divided and incohesive central bank and government and markets don’t like that one bit. We see that in the massive volatility in gilts and the pound.”
(Adds bond market reaction in third paragraph)
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