The shortest Prime Ministerial term in British history was accompanied by the greatest volatility in the long history of the UK government bond market. The long dated indexed linked gilt was trading at 115 when Mrs Truss walked into Number 10, it then fell to 52, a 65% loss on Kwasi Kwarteng’s mini budget before tripling, halving, and rallying to 128, a net gain of 11%. These were extraordinary moves.
With Kwasi Kwarteng’s ill-judged Budget largely reversed, cautious Rishi Sunak apparently set to be crowned as the new Prime Minister and sterling stable, the question arises whether the turmoil is over. It’s a reasonable assumption that the events of the last few weeks will not be repeated. However, dark clouds continue to dominate the UK economic skies.
The most significant achievement on Mrs Truss’ short tenure was the energy price scheme. The initiative has removed a huge potential hit to household incomes which would have guaranteed a recession over the winter. But in its place, we have higher mortgage rates and a threat to housing that could push the economy into a longer period of economic weakness.
To be sure, interest rates were excessively low before Mrs Truss came to power. In the absence of contrary policy, the Bank of England assumed British households would feel the full force of the surge in energy prices. The resultant recession would, in their view, have removed most of the remaining inflationary pressure leaving very little for them to do in the way of raising base rates. Remove the energy price-induced recession and base rates would rise much further.
The question is: how much further? At one-point, base rates were expected to peak at well over 6% next spring. That was far too high, and that number has edged down to 5% today. Even that would be quite a stretch. Bear in mind that fiscal policy is set to be tightened, real wages are falling and our biggest export market, Europe, is heading for recession. Mortgage Rates are currently comfortably over 5% even for a low loan-to-value mortgage. They may go lower if the authorities continue to keep National Savings rates lagging base rates.
But even this would represent a major drag on housing and push prices down. The decades of low interest rates pushing house prices higher are over. Weakness should not turn into disaster given that unemployment and gearing are low. But big problems lie ahead. Indeed, there are already widespread reports of falling house prices.
A final word on sterling. Having fallen as far as 1.04 against the dollar, sterling has staged a decent recovery. But as economic weakness becomes more apparent, our huge current account deficit will begin to weigh on the currency. Sterling is also a ‘risk off’ currency, so tends to do well when equities rally, as they have over the last two weeks. If, as we expect, equities come under further pressure over the next few months, sterling is likely to see renewed weakness. It could well end the year below parity against the dollar