Ten charts tell the story of a turbulent week for the pound, the market for UK government debt, the country’s main institutions of economic policy-making and the British public.
There hasn’t been this much excitement about sterling in 30 years. In a week reminiscent of the currency crisis of September 1992, the UK saw concerns that the pound would sink to parity with the dollar, turmoil in the bond market and the Bank of England forced to step in.
This raises a host of questions. What caused the financial market gyrations: was it really a reaction to the ‘mini-budget’ or something wider? Was the Bank right to respond? And what does it mean for the rest of us?
This column tells the story using ten charts running from official data. Most are interactive: you can use the date sliders to zoom in on what’s going on right now or zoom out to see the UK’s long-run history.
The background: prices, policy and debt
To understand the troubles this week, start with the fact that the UK is currently skewered on a fork with three sharp prongs. The first is prices: the extraordinary run-up of inflation over the past six months. Year-on-year prices rose above 10% and are still close to this (Chart 1).
Figure 1: Inflation (CPI, % change over 12 months)
The Bank of England, which mandated to hit an inflation target of 2% a year, began to raise the interest rate that it controls, aiming to tamp down inflation. Bank Rate has risen from 0.25% in 2021 to 2.25% (Chart 2). This is a large and rapid monetary tightening, something the UK has not seen for decades.
Figure 2: Bank of England interest rates (bank rate, %, 1975-2022)
Source: Bank of England
The Bank’s task, even before this week, was the most difficult it has faced for years. This is the second prong: tricky monetary policy. While the global financial crisis of 2007-09 and its aftermath were devastating in terms of employment and output, monetary policy decisions in the period from 2010 to 2020 were, in a sense, simple. Both output and inflation tended to be too low, both needed to be pushed up, and stimulative policy – low Bank Rate and quantitative easing (QE) – was a way to do this.
The current mix is different. The UK is like a house where one room – the GDP room (Chart 3) – is too cold and another – the inflation room – is too hot. But the radiators in the rooms have no individual controls, and there is just one thermostat. Do you turn it up or down?
Figure 3: GDP growth rate (quarterly, chained volume measure)
Source: ONS (Series: IHYQ)
The third prong is the state of the country’s public finances. The UK’s debt-to-GDP ratio has risen over the past 30 years. Two events – the global financial crisis and the Covid-19 pandemic – explain big changes. But even in calmer times, debt has tended to creep up (Chart 4).
Figure 4: Public sector net debt (% GDP)
Source: ONS (Series: HS6X)
Chancellor Kwasi Kwarteng’s budget last Friday was supposed to be a ‘mini’ one. In it, he set out a range of tax cuts and national insurance reductions, steps that would reduce the country’s tax revenue. This came on top of increased spending on a package to cap energy prices as a way to help households and firms facing higher costs. With income down and spending up, the implication would be more borrowing (Chart 5).
Figure 5: Public sector net borrowing (£ billion), actual and forecast
Sources: ONS, IFS, OBR. Note: The red bars are forecasted figures based on IFS analysis and OBR data
So, the government was due to sell additional new bonds – the IOUs known as gilts by which it funds public spending that exceeds tax revenues. At the same time, the Bank was set to re-sell bonds it had bought as part of QE. The supply of bonds, in other words, would expand. Prices duly fell. This was then reportedly amplified by pension funds, which became forced sellers. With the price of bonds tumbling, their yields – which move inversely to prices and represent the UK’s borrowing costs – shot up (Chart 6).
Figure 6: UK Government borrowing costs (spot curve, nominal)
Source: Bank of England
The UK’s currency – like its bonds – cheapened. A weaker real economy means less profit for firms and makes dividends less likely: this dulls the demand for UK currency to buy stocks and shares. The bond market turmoil meant lower demand for the sterling needed to buy bonds. Supply and demand were working against UK assets, and the currency duly depreciated fast against the dollar (Chart 7).
Figure 7: Sterling-dollar exchange rate (USD into GDP)
Source: Bank of England (Series: XUDULSS)
Was this an overreaction by international markets or a home-grown problem? The answer is a bit of both. It is certainly the case that bond markets more widely have seen some sharp moves, with the yield on the US ten-year bond – a vital global benchmark – creeping up and seeing some large daily moves (Chart 8). Stepping back (use the slider on the chart), it is clear that bond yields have been extraordinarily low for years.
Figure 8: US-UK ten year bonds
Sources: Bank of England, FRED
But some of it is home-made. One quick and dirty way to assess this is to compare the US and UK government yields. This can be thought of as the ‘UK effect’ – stripping out the global trend. Before this summer, the UK paid less on its ten-year IOUs than a comparable US bond. This reversed in August, with a noticeable spike over the past week. Since then, bond buying by the Bank of England has brought yields back down.
Figure 9: Borrowing costs – the UK effect (spread, UK vs US 10y bonds, premium over Germany)
Sources: Bank of England, FRED, Bundesbank
So, what does this mean for the rest of us? The first thing to realise is that, like it or not, we are all bond market investors. Whether through pensions (either private or employers) insurance funds or our banks, the vast majority of us have a claim on government bonds. Losses on these portfolios have long-term effects on our wealth.
More immediately, the hit will be via interest rates, and in particular mortgages. High street banks’ own funding costs tend to move in line with those of the government, and to be passed on to borrowers. Mortgage rates are likely to rise both because of the Bank Rate hike and due to higher bond yields (Chart 10).
Figure 10: UK household interest rates (%, credit cards/mortgages)
Source: Bank of England (Series: IUMCCTL, IUMTLMV)
This one-two punch could deliver a knockout blow, lowering household disposable incomes that have already been chipped away at by higher prices. While the pound may have bounced back, the economic impact will be a slower burn, felt over the coming years.