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Why did the pound strengthen as gilt yields reached fresh highs? (David G40 / Shutterstock)
In recent weeks, the pound has rather curiously strengthened even as government borrowing costs reached thirty-year highs.
The typical assumption is that higher borrowing costs will weaken a currency. That’s the result of economic logic, which dictates that less government spending power will translate to weaker long-term growth.
So why has this bond mayhem helped sterling? To answer that, we need to examine the nature of debt and the role it plays in shaping markets across the globe.
What is government debt?
Every government in the world issues debt of some form. Essentially, this is a relatively fast, relatively low-cost way to secure funds immediately and without having to raise taxes.
Most will issue bonds, which are bid on by investors in a process that impacts both the price investors pay as well as the payout (or the yield) that investment returns. The yield sometimes (but not always) comes on top of a floating rate tied to economic metrics or interest rates. With a large proportion of its debt pegged to the retail price index, that’s partly why the UK government is so sensitive to high inflation.
Government bonds can have different maturities. This just means the time between purchase and payout is different. So, for example, a 10-year gilt purchased in 2026 would mature in 2036, at which point the government would pay the money owed.
Institutional investors like large banks and pension funds are some of the biggest holders of government debt. Private investors can also get in on the fun. To both markets, government debt is a reliable store of liquidity, as the likelihood of a government defaulting on its debt as opposed to a company, for example, is significantly lower.
UK 10-year gilt yield:
How does this impact exchange rates?
Most of the time, government debt is used to gauge the health of an economy. That makes it similar to some of the other metrics you’re likely to see in the news, including GDP growth, unemployment and inflation. Things like government borrowing data can impact a currency and cause it to strengthen or weaken against its rivals.
High levels of debt among developed economies have caused a bit of anxiety in recent years, swelling dangerously close to 100% of GDP even for powerhouses like the United States. While there hasn’t been too much of an impact so far,
In more extreme cases, high levels of debt will result in a sustained flight away from a currency if investors believe it will collapse under its debt and be unable to pay the promised returns. The eurozone debt crisis shows the effect this can have on a currency.
GBP/EUR: the eurozone debt crisis
The sterling exception
So, all this begs the question: why did the pound strengthen as bond yields shot up?
Higher inflation and interest rate expectations raised the yield on debt, as it became seen as a riskier investment. Higher yields mean higher returns for investors. If those investors believe the government will honour its commitment to return their money, demand rises.
Another factor is that almost all of the UK’s debt is in sterling. Therefore, in order to purchase government debt, investors must first buy pounds, thereby increasing the value of the pound relative to other currencies.
Recent events are another example of the unpredictable, unreliable nature of currency markets. Assumptions long held by established economic thought are not always borne out by reality. That can have costly implications for your business if you decide to gamble your profit margins and cash against the will of the market.
Register with Smart Currency Business today or request a call back from our team to discuss how our comprehensive solutions can help protect your bottom line.
