U.K. government bond tumult spills over to U.S. and European markets

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The UK government debt turmoil sent shockwaves through global markets, causing US and European bonds to swing wildly.

“Bond markets are still highly correlated, but we’ve certainly seen the tail wagging the dog this week,” said Dickie Hodges, head of unconstrained fixed income at Nomura Asset Management. “The gilt movements were so large that they spilled over into European and US bond markets.”

The 10-year U.S. Treasury, the benchmark in the world’s largest and most important debt market, posted its biggest one-day rally since March 2020 on Wednesday after the Bank of England announced debt purchases. emergency bonds to stop UK public debt plummeting. The gains followed heavy losses for global bond markets since last Friday as the strong sell-off in gilts spread around the world.

Analysts and investors say some of the moves in Treasuries or German Bunds were caused by leveraged investors – who use debt to increase their gains and losses – dumping easily tradable assets elsewhere in order to hedge their losses in the UK. But the similar – albeit much more muted – movements in the United States and Europe are also due to the common challenges facing most major economies, namely how to rein in runaway inflation without stifling economic growth.

“While the UK is a basket case, the fact is that the same pressures are acutely felt elsewhere,” said Richard McGuire, rates strategist at Rabobank. “Investors are seeing the government’s ill-conceived experiment and wondering if it’s a sign of things to come in other countries.”

Following Chancellor Kwasi Kwarteng’s £45billion package of tax cuts and energy subsidies last Friday, traders quickly priced in a steeper rise in UK interest rates, betting that the BoE should tighten its monetary policy more quickly in order to offset the inflationary effects of the fiscal stimulus. . Eurozone markets also added expectations for a further European Central Bank rate hike in the coming year “out of sympathy,” McGuire said. He added that his clients, who invest in eurozone sovereign debt, currently have the UK at the top of their list of questions.

The global alignment of monetary policy also means that when a central bank changes direction, such as when the BoE decided this week to delay its quantitative tightening process, it raises questions about whether other central banks will follow. .

“In the US market, we are a bunch of single-celled monkeys. You see the Bank of England suddenly ending quantitative tightening and you think maybe the US will end quantitative tightening too,” said Edward Al-Hussainy, senior interest rate strategist at Columbia Threadneedle. .

Aftershocks from the UK crisis were particularly evident in the United States due to the volatile state of markets generally, analysts and investors said. The United States and the United Kingdom, among the world’s central banks, are raising interest rates at a rapid pace, which has created unusual price swings, even in generally ultra-stable markets, such as bonds. of the Treasury. Two- and 10-year Treasuries are both on track for their biggest sell-off on record this year.

We can expect a major market reaction given the historic change in monetary policy this year. But these moves were also exacerbated as uncertainty about the future direction of monetary policy pushed more cautious investors to the sidelines. With fewer investors in the market, price swings become even more dramatic, a phenomenon some investors have described as a “volatility vortex.”

“In times of high volatility, everything becomes correlated,” said John Briggs, head of US rates strategy at NatWest Markets.

“While what happens in the UK, objectively, shouldn’t have an impact on the Fed’s outlook or on inflation, the fact is that when the markets move this far, no one will be in the dark. Volatility breeds volatility,” Briggs said.

This week, two Fed officials indicated that the crisis in the United Kingdom could potentially create problems in the United States. Atlanta Fed Chairman Raphael Bostic said the UK’s tax plan and resulting market volatility could increase the chances of tipping the global economy into a recession. Incoming Boston Fed Chair Susan Collins also said that “a significant economic or geopolitical event could push our economy into a recession as policy tightens further.”

“There’s money coming and going that keeps the different national markets in sync with each other,” said Gregory Whiteley, portfolio manager at DoubleLine. “It’s a natural spillover when money moves between markets to take advantage of price movements.”

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