UK steps in to restore market stability

The Bank of England sought to restore order to the market after tax cuts from Truss administration prompted a big selloff in the equity, bonds, and pounds markets. The central bank pledged to buy 65 billion pounds ($69.4 billion) of long-dated gilts, making it the second central bank in the world to initiate quantitative tightening following the US Federal Reserve.

The market sees the massive tax cuts as the reason behind the selloff in UK markets since last Friday. Measures of the sweeping program announced last Friday include: 1) cancellation of a planned hike in corporation tax to 25%, keeping it at 19%; 2) a reduction in the basic rate of income tax from 20 pence to 19 pence; 3) decreasing the 45% tax paid on incomes over £150k, lowering the top rate to 40%. The UK government claims that 31 million people will save an average of £170 per year. However, less than 50% of the UK population would actually benefit from this policy, starting next April. The so-called “sweeping” tax cuts will not be as impactful as the US fiscal policy since 2020.

The British pound’s long-term vulnerability can be attributed to 2 fundamental factors: 1) lack of foreign exchange reserves; 2) lack of tools to intervene the market with monetary policy.

The dollar keeps edging up this year and the DXY index has reached 114 this week. The 3 largest components behind DXY index are: EUR-57.6%, JPY-13.6%, and GBP-11.9%. The following 3 graphs show US trades with EU, Japan, and the UK. The blue column represents US exports to that region, the orange column represents US imports from that region, the gray line represents imports + exports, and the yellow line represents the US trade balance with that region.

Over the past 20 years, the changes in trade volumes with the US and the above 3 regions are: EU +100%, Japan +0%, UK +50%. However, the US trade volumes with all other regions in the world has increased over 130% over the past 20 years as shown below. This suggests that the overall percentage of trade between US and the 3 regions mentioned above has declined over the past 2 decades.

The imports and exports are almost balanced in trades between the US and UK, which means that the UK didn’t earn much surplus dollars from the US. In comparison, Japan has always had a surplus in trades with the US, which granted the Bank of Japan with a much bigger foreign exchange reserve than the Bank of England. The graph below shows that the foreign exchange reserve of BoJ (red) is nearly 9 times bigger than that of BoE (green).

The foreign exchange reserve of the UK is only $110 billion, even less than that of Singapore, which is $270 billion. Moreover, Singapore has a population of 5 million, while the UK has one of 67 million. The  pound will be in a very precarious position when the dollar is strong. Furthermore, the UK debt ratio has risen even higher than that of the US since 2000, which left limited tools for BoE to intervene with its monetary policy. The graph below shows UK national debt (white) and US treasury debt (blue) since 2000.

#1. Nord Stream reports “unprecedented” damage to its key pipeline to Germany

• Nord Stream operator said three offshore gas pipelines were damaged in one day, and a fourth leak on the Nord Stream pipelines has been reported off southern Sweden on Thursday. 

• NATO formally blames sabotage for Nord Stream’s pipeline damage. Russia says Nord Stream sabotage likely to be a state-sponsored act.

#2. Apple falls after reportedly ditching iPhone production boost

• Apple is backing off plans to increase production of its new iPhone this year after an anticipated surge in demand failed to materialize.

• Apple shares fell by 1.27% on Wednesday. The shares are down 18% this year, compared with a 23% drop in the S&P 500 index.

#3. 10-year yield drops the most since 2020 after reaching 4%

• The 10-year treasury yield dropped the most since 2020 on Wednesday, despite briefly topping 4% earlier in the session, after the BoE announced a bond-buying plan to stabilize the British pound.

• US treasury yields have been rising recently as traders weigh comments from several Fed speakers earlier in the week. Their broadly hawkish tone suggested that further interest rates hikes will be implemented.

#4. Hurricane Ian hits Florida

• Hurricane Ian weakened to a tropical storm as it churned through central Florida with maximum wind speeds of 65 miles an hour. The storm is expected to fully cross over the state and reach the Atlantic Ocean by Thursday.

• More than 2 million are without power. The storm caused widespread transportation disruptions, including airport closures and at least 2,160 flight cancellations on Wednesday. Biden approved Florida’s disaster declaration.

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