UK bonds surged after Boris Johnson pulled out of the race to become prime minister, leaving Rishi Sunak as the frontrunner, a candidate investors expect will restore credibility to economic policy making and help calm the nation’s rattled markets.
Short-dated notes led the rally, sending the yield on the two-year note lower by as much as 36 basis points to 3.44%. Traders are also paring bets on the extent of interest-rate hikes by the Bank of England. The result of the contest could be announced as soon as today if Sunak emerges as the only candidate with sufficient backing from lawmakers.
Having served as chancellor in the government of Johnson, a potential Sunak premiership is seen as being better equipped to address the nation’s financial challenges. Liz Truss resigned last Thursday after just weeks in the top job and after a U-Turn on her key pledge of massive unfunded tax cuts, which also led to the firing her first choice of chancellor. Her original economic plan, including a big boost in borrowing to pay for tax cuts, rattled investors.
“Markets trust in his fiscal strategies,” Pooja Kumra, rates strategist at Toronto-Dominion Bank, said of Sunak. “With a fiscally conservative PM, the amount of tightening required from BOE also eases.”
Sunak warned during the first leadership campaign — in which he was beaten by Truss — that the outgoing administration’s fiscal measures would push Britain’s economy to the brink of collapse. That explains some of the positive reaction on Monday, despite the former chancelor having given no public indication of what he’d do as prime minister since the summer months.
Traders continued to cut wagers on the extent of the hikes by the Bank of England. The key rate is now seen peaking at about 5.12% by August. Expectations of a jumbo one percentage point increase when policy makers meet next Thursday have also faded, though a 75 basis point hike is still fully priced.
Standing in Sunak’s way is Penny Mordaunt, though her public endorsements from Tory MPs are way below the 100 votes needed for a nomination. That could see him potentially named leader as soon as this afternoon, with the medium-term fiscal policy statement from Chancellor of the Exchequor Jeremy Hunt due a week today. The appointment of Hunt, who engineered the reversal of Truss’ policies, has already helped calm markets.
“I think the assumption is that Sunak wins, Hunt stays in No. 11 and his current fiscal plans are endorsed. They represent a big shift in fiscal policy from easy to tight,” said Kit Juckes, chief FX strategist at Societe Generale SA.
Once the initial optimism has faded, attention is likely to return to the UK’s bleak economic outlook: inflation at a 40-year high, soaring interest rates, depressed consumer sentiment, and a potentially severe recession. Net issuance of gilts for the next fiscal year remains vast and borrowing costs are high.
Some of the so-called Truss premium is still priced into gilts though. The 10-year yield is trading just below 4%, nearly 50 basis points higher than where it closed on Sept. 22, the day before Truss’ mini-budget. The plans laid out that day triggered a bond rout that pushed yields to their highest in years and forced the central bank to step in to stabilize markets.
The pound earlier gained as much as 0.9% to pass $1.14 but has since erased most of that move. It’s languishing well below the peaks reached during the first leadership contest over the summer, weighed down by huge economic and fiscal headwinds ahead.
The outlook for the UK’s credit score was revised to negative by Moody’s Investors Service on Friday. The rating firm said the change in the outlook was driven by “heightened unpredictability in policymaking” amid weaker growth prospects and high inflation and “risks to debt affordability from likely higher borrowing.”
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