What on earth is happening in UK markets and why is the Bank of England struggling to address it?

Published

3 years ago

October 12, 2022

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This is starting to look a little… unnerving.

This morning the Bank of England tweaked its emergency intervention into the government bond (gilts) market for a second successive day.

The details are somewhat arcane: yesterday it doubled the amount it was offering to buy each day; today it said it would widen the stock of assets it is offering to buy. But what matters more is the big picture.

The government bond market is – in the UK and elsewhere – best thought of as the bedrock of the financial system.

The government borrows lots of money each year at very long durations and these bonds are bought by all sorts of investors to secure a low but (usually) reliable income over a long period of time.

Compared to other sorts of assets – such as the shares issued by companies or for that matter cryptocurrencies – government bonds are boring. Or at least, they’re supposed to be boring.

They don’t move all that much each day and the yield they offer – the interest rate implied by their prices – is typically much lower than most other asset classes.

But recently the UK bond market (we call them gilts as a matter of tradition, short for gilt-edged securities, because in their earliest embodiment they were pieces of paper with golden edges) has been anything but boring.

In the wake of the mini-budget, the yield on gilts of various different durations leapt higher – much higher. The price of the gilts fell dramatically. That, ultimately, was what the Bank of England was originally responding to a couple of weeks ago.

But to understand what a tricky position it’s in, you need to zoom out even further. For while it’s tempting to blame everything on the government and its mini-budget, it’s fairer to see this as the straw that broke the market’s back. For there are three intersecting issues at play here.

The end of the low interest rate era

The first is that we are in the midst of a seismic economic moment.

For the past decade and a bit, we (here in the UK but also in the US, Eurozone and throughout most of the world) have become used to interest rates being incredibly low.

More than low, they were effectively negative, because in the wake of the financial crisis central banks around the world pumped trillions of dollars into the financial plumbing.

They mostly did so (in this case the method really matters) by buying up vast quantities of government debt. The Bank of England became the single biggest owner of UK gilts, at one point owning roughly a third of the UK’s national debt.

It was an emergency measure designed to prevent a catastrophic rerun of the Great Depression, but the medicine has proven incredibly difficult to wean ourselves off.

A few years ago, when the US Federal Reserve thought out loud about reversing quantitative easing (QE) – as the bond-buying programme is called – it triggered such a panic in bond markets that it immediately thought twice about it.

Since then, it and other central banks like the Bank of England have been as careful as possible not to frighten these markets. They have managed to end QE and, in the case of the Fed, have begun to reverse it. This is a very, very big deal.

Think about it for a moment.

All of a sudden, the world’s biggest buyers of arguably the world’s most important asset class have become big sellers of them.

In the UK, the Bank of England was due to begin its own reversal of QE round about now.

Tensions were, even before the government’s ham-fisted fiscal statement, about as high as they get in this normally-dull corner of financial markets.

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Reliance on complex derivatives

The second issue (and this is something only a few financial analysts and residents of the bonds market fully appreciated up until a few weeks ago) is that the era of low interest rates had also driven investors into all sorts of strange strategies in an effort to make a return.

Most notably, some pension funds had begun to rely on complex derivatives to keep earning a decent return each year while complying with regulations.

These so-called Liability Driven Investment strategies were well-suited for the nine-times-out-of-ten when the gilts market was boring. But as interest rates began to rise this year – partly because inflation was rising and central banks were beginning to raise interest rates and reverse QE; partly because investors twigged that the next prime minister seemed quite keen on borrowing more – these strategies began to run into trouble.

They were feeling the strain even before Friday 23 September.

Hard to think of a worse moment for an uncosted fiscal plan

But that brings us to the third of the issues here: the mini-budget.

The government bond market was already, as we’ve established, in a sensitive position.

Markets were, as one adviser to the Truss team warned them, febrile. It is hard to think of many worse moments for a new, untried and untrusted government to introduce uncosted fiscal plans. Yet that is what Kwasi Kwarteng did in his mini-budget.

The problem wasn’t really any single specific policy, but the combination.

It wasn’t about the sums (or lack thereof) but a dramatic loss of credibility for the government.

All of a sudden, the UK, which is anyway very reliant on external funding from overseas investors, seemed to surrender the benefit of the doubt.

Traders began to pull money from the UK, pushing the pound lower and forcing interest rates in the bond market higher (after all, if people are reluctant to lend to you, you have to offer them a higher rate to persuade them).

The new Chancellor seems genuinely to have been completely taken unawares by the reaction to his plan.

Yet the reality is that it so happened (in fiscal terms at least) to be about the worst possible pitch at the worst possible time. And it pushed up interest rates on government debt dramatically.

Wave of defaults could lead to a total breakdown of system

As I say, this was far from the only thing going on in markets.

On top of all the above, there were and are question marks about whether the Bank of England is acting fast enough to clamp down on inflation.

But these questions, and many others, were effectively swamped by the catastrophic surge in interest rates following the mini-budget.

Catastrophic because the increase in rates was so sharp it threatened the very functioning of the gilts market – this bedrock of the financial system.

And for those liability-driven investors in the pensions sector, it threatened to cause a wave of defaults which could, the Bank of England feared, lead to a total breakdown of the system within days or even hours.

This fear of what it called a “run dynamic” – a kind of wholesale equivalent to what we saw with Northern Rock, where a firesale of assets causes values to spiral ever downwards – sparked it into action.

It intervened the Wednesday after the mini-budget, offering to buy £65bn worth of the longer-dated gilts most affected. The intervention, it said, was taken to prevent the financial system from coming to harm.

But the method of intervention was quite significant.

After all, wasn’t buying bonds (with printed money) precisely what the Bank had been doing for the past decade or so through its QE programme?

Well in one sense… yes. The Bank insisted this was different: that this was not about injecting cash into the economy to get it moving but to deal forensically with a specific issue gumming up the markets. Financial stability, not monetary policy.

Even so, the paradox is still hard to escape. All of a sudden the Bank has gone from promising to sell a bucket load of bonds to promising to buy them.

Market reaction

The initial market reaction was overwhelmingly encouraging: the pound rose and interest rates on government bonds fell.

It was precisely what the Bank would have wanted – and most encouragingly it seemed to be driven not by the amount of cash the Bank was putting in (actually surprisingly few investors took up its offer to buy bonds), but sentiment.

The vicious circle precipitated by the mini-budget seemed to be turning around.

But in the past few days of trading, things have unravelled again.

The pound has fallen; the yields on bonds have risen, back more or less to where they were shortly before the Bank intervened a couple of weeks ago. It is unnerving.

And this brings us back to where we started. The Bank has bolstered its intervention a couple of times but it hasn’t brought yields down all that much – indeed, quite the contrary.

As of this lunchtime Tuesday the yields on long-dated UK government bonds were even higher than they were 24 hours earlier.

Why? One obvious issue is that the Bank’s intervention is strictly time-limited. It is due to expire at the end of this week. That raises a few other questions. First, will the pension funds reliant on those liability driven investments have untangled themselves by then? No-one is entirely sure. For a sense of how worried investors are about this, just look at what happened to the pound tonight after the Bank’s governor, Andrew Bailey, insisted the emergency programme will indeed end on Friday. It plummeted off a cliff-edge, instantly losing almost two cents against the dollar.

Second, will the government have become more credible in the market’s eyes by then? Almost certainly not. Aside from anything else, it isn’t due to present its plans for dealing with the public finances until the end of this month.

Third, what does all this mean for monetary policy and the end of QE? If we are to take them at their word, after ending this scheme the Bank will shortly begin the process of selling off bonds all over again.

So, one day they’re gearing up to be a massive seller; the next a massive buyer; the next a massive seller all over again.

Little matter that the stated reasons for the bond buying/selling are different. From the market’s perspective, no one is quite sure where they stand anymore.

In this final sense, the UK has unwittingly turned itself into a kind of laboratory for the epoch we’re in right now.

Everyone was expecting bumps in the road as the era of easy monetary policy came to an end.

It seems we are currently experiencing some of those bumps. And it just so happened that, thanks in large part to its new government, the UK found itself careering towards those bumps rather than braking before hitting them.

Business

Post Office to unveil £1.75bn banking deal with big British lenders

Published

14 hours ago

April 25, 2025

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Post Office to unveil £1.75bn banking deal with big British lenders

The Post Office will next week unveil a £1.75bn deal with dozens of banks which will allow their customers to continue using Britain’s biggest retail network.

Sky News has learnt the next Post Office banking framework will be launched next Wednesday, with an agreement that will deliver an additional £500m to the government-owned company.

Banking industry sources said on Friday the deal would be worth roughly £350m annually to the Post Office – an uplift from the existing £250m-a-year deal, which expires at the end of the year.

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The sources added that in return for the additional payments, the Post Office would make a range of commitments to improving the service it provides to banks’ customers who use its branches.

Banks which participate in the arrangements include Barclays, HSBC, Lloyds Banking Group, NatWest Group and Santander UK.

Under the Banking Framework Agreement, the 30 banks and mutuals’ customers can access the Post Office’s 11,500 branches for a range of services, including depositing and withdrawing cash.

The service is particularly valuable to those who still rely on physical cash after a decade in which well over 6,000 bank branches have been closed across Britain.

In 2023, more than £10bn worth of cash was withdrawn over the counter and £29bn in cash was deposited over the counter, the Post Office said last year.

A new, longer-term deal with the banks comes at a critical time for the Post Office, which is trying to secure government funding to bolster the pay of thousands of sub-postmasters.

Reliant on an annual government subsidy, the reputation of the network’s previous management team was left in tatters by the Horizon IT scandal and the wrongful conviction of hundreds of sub-postmasters.

A Post Office spokesperson declined to comment ahead of next week’s announcement.

Business

Trump trade war: How UK figures show his tariff argument doesn’t add up

Published

14 hours ago

April 25, 2025

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Trump trade war: How UK figures show his tariff argument doesn't add up

As Chancellor Rachel Reeves meets her counterpart, US Treasury secretary Scott Bessent to discuss an “economic agreement” between the two countries, the latest trade figures confirm three realities that ought to shape negotiations.

The first is that the US remains a vital customer for UK businesses, the largest single-nation export market for British goods and the third-largest import partner, critical to the UK automotive industry, already landed with a 25% tariff, and pharmaceuticals, which might yet be.

In 2024 the US was the UK’s largest export market for cars, worth £9bn to companies including Jaguar Land Rover, Bentley and Aston Martin, and accounting for more than 27% of UK automotive exports.

Little wonder the domestic industry fears a heavy and immediate impact on sales and jobs should tariffs remain.

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American car exports to the UK by contrast are worth just £1bn, which may explain why the chancellor may be willing to lower the current tariff of 10% to 2.5%.

For UK medicines and pharmaceutical producers meanwhile, the US was a more than £6bn market in 2024. Currently exempt from tariffs, while Mr Trump and his advisors think about how to treat an industry he has long-criticised for high prices, it remains vulnerable.

The second point is that the US is even more important for the services industry. British exports of consultancy, PR, financial and other professional services to America were worth £131bn last year.

That’s more than double the total value of the goods traded in the same direction, but mercifully services are much harder to hammer with the blunt tool of tariffs, though not immune from regulation and other “non-tariff barriers”.

The third point is that, had Donald Trump stuck to his initial rationale for tariffs, UK exporters should not be facing a penny of extra cost for doing business with the US.

The president says he slapped blanket tariffs on every nation bar Russia to “rebalance” the US economy and reverse goods trade ‘deficits’ – in which the US imports more than it exports to a given country.

That heavily contested argument might apply to Mexico, Canada, China and many other manufacturing nations, but it does not meaningfully apply to Britain.

Figures from the Office for National Statistics show the US ran a small goods trade deficit with the UK in 2024 of £2.2bn, importing £59.3bn of goods against exports of £57.1bn.

Add in services trade, in which the UK exports more than double what it imports from the US, and the UK’s surplus – and thus the US ‘deficit’ – swells to nearly £78bn.

That might be a problem were it not for the US’ own accounts of the goods and services trade with Britain, which it says actually show a $15bn (£11.8bn) surplus with the UK.

You might think that they cannot both be right, but the ONS disagrees. The disparity is caused by the way the US Bureau of Economic Analysis accounts for services, as well as a range of statistical assumptions.

“The presence of trade asymmetries does not indicate that either country is inaccurate in their estimation,” the ONS said.

That might be encouraging had Mr Trump not ignored his own arguments and landed the UK, like everyone else in the world, with a blanket 10% tariff on all goods.

Trade agreements are notoriously complex, protracted affairs, which helps explain why after nine years of trying the UK still has not got one with the US, and the Brexit deal it did with the EU against a self-imposed deadline has been proved highly disadvantageous.

Business

Public failed by water regulators and government as bills rise, spending watchdog says

Published

21 hours ago

April 25, 2025

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Public failed by water regulators and government as bills rise, spending watchdog says

Water regulators and the government have failed to provide a trusted and resilient industry at the same time as bills rise, the state spending watchdog has said.

Public trust in the water sector has reached a record low, according to a report from the National Audit Office (NAO) on the privatised industry.

Not since monitoring began in 2011 has consumer trust been at such a level, it said.

At the same time, households face double-digit bill hikes over the next five years.

The last time bills rose at this rate was just before the global financial crash, between 2004-05 and 2005-06.

Regulation failure

All three water regulators – Ofwat, the Environment Agency and Drinking Water Inspectorate – and the government department for environment, food and rural affairs (Defra) have played a role in the failure, the NAO said, adding they do not know enough about the condition or age of water infrastructure and the level of funding needed to maintain it.

Since the utilities were privatised in 1989, the average rate of replacement for water assets is 125 years, the watchdog said. If the current pace is maintained, it will take 700 years to replace the existing water mains.

Water firms have grappled with leaky pipes and record sewage outflows into UK waterways in recent years, with enforcement action under way against all wastewater companies.

Despite there being three regulators tasked with water, there is no one responsible for proactively inspecting wastewater to prevent environmental harm, the report found.

Instead, regulation is reactive, fining firms when harm has already occurred.

Financial penalties and rewards, however, have not worked as water company performance hasn’t been “consistent or significantly improved” in recent years, the report said.

‘Gaps, inconsistencies, tension’

The NAO called for this to change and for a body to be tasked with the whole process and assets. At present, the Drinking Water Inspectorate monitors water coming into a house, but there is no entity looking at water leaving a property.

Similarly no body is tasked with cybersecurity for wastewater businesses.

As well as there being gaps, “inconsistent” watchdog responsibilities cause “tension” and overlap, the report found.

The Environment Agency has no obligation to balance customer affordability with its duty to the environment when it assesses plans, the NAO said.

Company and investment criticism

Regulators have also been blamed for failing to drive enough funding into the water sector.

From having spoken to investors through numerous meetings, the NAO learnt that confidence had declined, which has made it more expensive to invest in companies providing water.

Even investors found Ofwat’s five-yearly price review process “complex and difficult”, the report said.

Financial resilience of the industry has “weakened” with Ofwat having signalled concerns about the financial resilience of 10 of the 16 major water companies.

Most notably, the UK’s largest provider, Thames Water, faced an uncertain future and potential nationalisation before securing an emergency £3bn loan, adding to its already massive £16bn debt pile.

Water businesses have been overspending, with only some extra spending linked to high inflation in recent years, leading to rising bills, the NAO said.

Over the next 25 years, companies plan to spend £290bn on infrastructure and investment, while Ofwat estimates a further £52bn will be needed to deliver up to 30 water supply projects, including nine reservoirs.

What else is going on?

From today, a new government law comes into effect which could see water bosses who cover up illegal sewage spills imprisoned for up to two years.

Such measures are necessary, Defra said, as some water companies have obstructed investigations and failed to hand over evidence on illegal sewage discharges, preventing crackdowns.

Meanwhile, the Independent Water Commission (IWC), led by former Bank of England deputy governor Sir Jon Cunliffe, is carrying out the largest review of the industry since privatisation.

What the regulators and government say?

In response to the report, Ofwat said: “The NAO’s report is an important contribution to the debate about the future of the water industry.

“We agree with the NAO’s recommendations for Ofwat and we continue to progress our work in these areas, and to contribute to the IWC’s wider review of the regulatory framework. We also look forward to the IWC’s recommendations and to working with government and other regulators to better deliver for customers and the environment.”

An Environment Agency spokesperson said: “We have worked closely with the National Audit Office in producing this report and welcome its substantial contribution to the debate on the future of water regulation.

“We recognise the significant challenges facing the water industry. That is why we will be working with Defra and other water regulators to implement the report’s recommendations and update our frameworks to reflect its findings.”

A Defra spokesperson said: “The government has taken urgent action to fix the water industry – but change will not happen overnight.

“We have put water companies under tough special measures through our landmark Water Act, with new powers to ban the payment of bonuses to polluting water bosses and bring tougher criminal charges against them if they break the law.”

Water UK, which represents the water firms, has been contacted for comment.