What is happening in the UK?
Last week, fiscal showdown in the UK can be seen. The shocks in financial markets – most notably in the currency but also in sovereign bond markets (GBP and gilts, respectively) – can easily offset any misguided fiscal policy and trigger systemic risks on top. I

In the case of UK pension funds, the breakdown in gilts shows how relentless rate increases make the system increasingly vulnerable. So vulnerable that any additional shock can trigger systemic crises such as a blow up of fancy financial instruments, with the risk of large players like pension funds going down. The good news is that central banks do not seem to be asleep at the wheel.

The Bank of England (BoE) intervened and introduced something to the tune of ‘yield-curve control’, i.e. the BoE froze the whole yield curve to levels fit to be managed by the players. That diffused the situation last week. Yet it remains to be seen how sustainable that fix actually is, which also depends on the stubbornness of the government pushing through its programmes.

On a broader scale, the UK outlines what the endgame in this tightening cycle may look like: the rate hikes stop when something breaks – either the economy goes into freefall recession, or a systemic crisis starts. Or, the outcome is a combination of both.

What this means for investors?
Such tipping points do not mean immediate reversals of policy, but an end to the shock treatments against inflation during most of this year. We are not there yet and the panic in markets may have further to go. Yet after recent events in the UK and in continental European banks, the turning point may be much nearer than thought. For investors, patience and good nerves are called for, until it is time to get ready for the shift.

A closer look at the UK - is Truss’s U-turn good enough?
Last week, we pondered on what could restore market confidence in the UK, after markets had punished the Growth Plan 2022, due to its combination of unfunded tax cuts and additional spending for the energy bill cap.

We identified two factors: first, the government unveiling more detail on the funding and impact on the fiscal balance; and second, the Bank of England (BoE) fulfilling market expectations of larger policy rate hikes that had soared to above 6% for next year and implied 150 basis points at the next meeting on 3 November.

However, early Monday morning, the Truss government performed a remarkable (and humiliating) U-turn, scrapping the announced cut of the highest income tax rate. This might have been driven less by markets than by politics. Resistance within the Conservative Party was building, after opinion polls showed a large shift in favour of Labour due to the “tax cuts for the rich”.

As the dust settled last week, with the BoE announcing the emergency gilt purchases, the pound stabilised and recovered to levels around EUR/GBP 0.88.

What lies ahead of recovery?
Much of the recovery hinges also on expectations of higher policy rates. In reaction to Monday’s events, markets started to trim back the expectations further to below 125bps for the next meeting, but the pound strengthened towards EUR/GBP 0.87, showing some further relaxation in market tensions.

We question, however, how far the recent events can help restore confidence and normalise markets. The revoked tax cut is not the largest item in terms of economic and fiscal balance impact – the general income tax rate cut to 19%, the cancelled corporate tax hike, and the energy bill cap weigh more. Therefore, markets may remain tense and the pound prone to further setbacks should the BoE deliver less.

And this is not unlikely, as the UK is already in a recession and higher gilts tighten financial conditions and create more short-term growth risks, while the impact of the plans will unfold rather in the mid term. Relief could be given if the government further waters down its plans during the upcoming party congress and legislative process.