The British economy has taken a sharp turn for the worse, contracting by 0.3% in the third quarter as the fallout from the Iran conflict sends shockwaves through global markets. The Treasury, in a hastily convened briefing this morning, warned that further turbulence is inevitable, with gilt yields spiking and the pound sliding to a three-year low against the dollar. This is not a blip. This is the market punishing fiscal profligacy compounded by geopolitical chaos.
Let's be clear about what we are seeing. The contraction is not a surprise to anyone who has been watching the bond markets. The yield on the 10-year gilt has surged to 4.8%, a level not seen since the aftermath of the 2008 financial crisis. Investors are demanding a higher premium to hold UK debt, and they are doing so for good reason. The government's borrowing binge, accelerated by Covid-era spending, has left the fiscal accounts looking like a bar tab after a wedding party. Now, with energy prices soaring due to disruptions in the Strait of Hormuz, the inflation genie is well and truly out of the bottle. Consumer prices rose 6.2% in September, far above the Bank of England's 2% target. The Monetary Policy Committee is caught between a rock and a hard place: raise rates to tame inflation and choke off growth, or hold steady and watch the pound get pummelled.
The Treasury's warning of further turbulence is a masterclass in understatement. Capital flight is already underway. Foreign investors, who hold roughly a quarter of UK gilts, are selling. The latest data from the Bank of England shows net foreign purchases of UK government bonds fell to a mere £1.2 billion in August, the lowest since the Brexit referendum. They are moving their money to safe havens: Swiss francs, US Treasuries, even gold. The irony is that the UK, once seen as a bastion of stability, is now being lumped in with the eurozone periphery. The spread between UK and German 10-year bonds has widened to 150 basis points, a level that screams 'risk off'.
And what of the consumer? The average household is feeling the pinch. Petrol prices have hit £1.80 per litre, heating bills are up 40% year-on-year, and mortgage rates are climbing. The average two-year fixed-rate mortgage is now above 6%, a level that will cause pain for the two million homeowners due to refinance next year. The Bank of England's own stress tests suggest that a third of those households could see their disposable income shrink by 20% or more. This is not a recipe for a consumer-led recovery.
The government's response, so far, has been predictably muddled. The Chancellor has announced a 'fiscal resilience review' but has ruled out any immediate tax cuts or spending increases. Translation: they are hoping the storm passes. But storms do not pass when you are sitting in a leaking boat. The Treasury needs to make a credible commitment to fiscal consolidation, but the political appetite for austerity is, shall we say, limited. The result is a policy vacuum that the markets are filling with higher yields and a weaker currency.
Meanwhile, the Iran war continues to destabilise the Middle East. Oil prices have breached $100 a barrel, and if the conflict escalates, we could see $120. For a net importer of energy like the UK, this is a direct tax on growth. Manufacturing output fell 1.2% in August, the largest drop since the lockdowns. Business investment is being shelved. Why invest when the outlook is so uncertain?
So where does this leave us? The UK economy is in a stagflationary spiral: high inflation, low growth, and rising unemployment. The Treasury's warning is a recognition that the medicine will be painful. Interest rates will have to go higher, perhaps to 6% or more, to restore credibility. That will cause a recession, but it may be the only way to stop the rot. The alternative, a full-blown sterling crisis, would be far worse. Remember 1976, when the UK had to go cap in hand to the IMF? That is the spectre haunting this Treasury.
For now, the markets are watching, waiting, and pricing in more pain. The bottom line is this: the UK cannot borrow its way out of a crisis caused by over-borrowing. Fiscal discipline, however politically unpalatable, is the only path back to stability. The Treasury knows it. The question is whether the government has the nerve to act.
