Liz Truss Aug 6 2022 3

This has turned into one of those weeks that's a turning point in real time.

Liz Truss made a lot of promises in her UK leadership run and they were all predicated on the idea of easy money. Cutting taxes and boosting spending works for awhile and is especially useful when the central bank cooperates but we've hit the limit. The UK debt market is in the fetal position today. The game is up.

UK gilt yields weekly

A particularly worrisome part of the package is the energy price cap for consumers. The move to limit bills to £2500 means that governments take all the risk for energy prices with no consumer incentive for conservation. That's a £60 billion line item this year but it could be much more (or less).

What it will do though is send a shiver down the spine of politicians in the rest of Europe. Many countries are working out energy crisis schemes at the moment and it's now much more likely that the UK model won't be used. I'd mused that the shift of consumer/business energy liabilities to the government would be bullish for European equities but now that's unlikely. Instead what's happening is that central banks are working against governments which now have to navigate the crisis along with spiralling borrowing costs.

On balance, that will mean more of the burden of the crisis falls on consumers and business. Of course that means a harsher crisis and worse growth.

It's a lose-lose situation for currencies and Deutsche Bank today warns there's only a narrow way out.

It is extremely unusual for a developed market currency to weaken at the same time as yields are rising sharply. But, this is exactly what has happened since the new Chancellor’s announcement. We worry that investor confidence in the UK's external sustainability is being eroded fast. And the only thing that can prevent the pound from weakening is a very aggressive Bank of England hiking cycle that raises the return on gilts. The market has already repriced UK terminal rates to above 5%, the highest of any other developed market country. But yesterday, the Bank of England once again hiked by less than market pricing. If the Bank of England doesn’t follow through with this pricing there will likely be even more currency weakness to go.

Cable is down 204 pips to 1.1055 today, a 35-year low.

GBPUSD monthly chart

As bad as it is in the UK, the turning point in bond market discipline has equally-ugly implications abroad. The hope was that Europe (and the world) could get through the energy crisis and then tackle debt sustainability. Now politicians have the impossible task of doing both at the same time.

Given that the impetus to spend isn't likely to turn as fast as the bond market, the relief valve will be in currencies. But that will create a negative feedback loop with inflation and further rate hikes.

Emerging markets have had to deal with these tradeoffs forever and there's no easy way out. Given what's happened in gilts today, developed market politicians should be frightened.