The US economy continues to surprise to the upside, with GDP growth exceeding expectations and unemployment at historic lows. But beneath the surface, the Federal Reserve’s accommodative stance is stoking inflationary pressures that may yet unravel the post-pandemic recovery. Meanwhile, across the Atlantic, Britain’s commitment to fiscal rectitude stands as a lonely bulwark against global profligacy.
Recent data out of Washington show that the US economy expanded at an annualised rate of 4.9% in the third quarter, driven by strong consumer spending and inventory accumulation. The labour market remains robust, with the economy adding 336,000 jobs in September. Yet the devil is in the details. Core inflation, as measured by the Personal Consumption Expenditures index, is running at 3.7% for September, well above the Fed’s 2% target. Bond markets are starting to take notice: the 10-year Treasury yield has surged to 5%, its highest level in 16 years. This is a clear signal that investors are demanding a premium to hold US debt, wary of the fiscal trajectory under a government that seems incapable of passing a budget without last-minute theatrics.
In London, the view from the City is one of cautious vindication. Chancellor Jeremy Hunt’s autumn statement, due next month, is expected to reaffirm the government’s commitment to reducing debt as a share of GDP. British gilt yields have risen in sympathy with US Treasuries but remain anchored by the Office for Budget Responsibility’s (OBR) fiscal rules. The UK’s deficit is projected to fall to 2.8% of GDP in 2023-24, compared to the US deficit of over 6%. This fiscal discipline is not without cost. It constrains public investment and leaves little room for tax cuts ahead of a likely general election in 2024. But in a world of rising rates and skittish investors, it is a sign of strength.
Capital flight from the US is not yet a stampede, but there are early warning signs. Foreign holdings of US Treasuries have fallen to $7.5 trillion, down from a peak of $7.7 trillion in 2022. China has been reducing its exposure, selling $46 billion of US bonds in the second quarter alone. Meanwhile, the dollar remains the world’s reserve currency, but its dominance is being gently challenged. Central banks are diversifying into gold and other currencies, including sterling. The pound has appreciated 3% against the dollar this year, a reflection of relative stability rather than outright strength.
For the UK, the biggest risk is that higher US rates force the Bank of England to keep its own rates elevated for longer, choking off the nascent recovery. The housing market is already feeling the strain, with mortgage approvals at their lowest since 2020. But the alternative is unthinkable. If Britain abandoned its fiscal discipline, it would join the ranks of the fiscal sinners, facing the wrath of bond markets. The Liz Truss mini-budget disaster of last year is still fresh in the memory.
The message from the markets is clear: there is no free lunch. Governments that live beyond their means will eventually be punished. The US may be enjoying a sugar high, but the hangover awaits. Britain, for all its problems, is sticking to the boring but virtuous path. It is not a recipe for exciting growth, but in times of global uncertainty, boring is beautiful. The bedrock of global stability is not built on central bank alchemy. It is built on the willingness of governments to balance their books. That lesson, so painfully learned in the UK, is one the US would do well to remember.
As the famous investor Warren Buffett once said, “Only when the tide goes out do you discover who's been swimming naked.” The tide of low interest rates has gone out. Britain is still wearing its trunks. The US, I fear, is not.
For now, the markets are giving the UK the benefit of the doubt. But we must remain vigilant. Fiscal discipline is not a one-off event. It is a daily struggle against the temptations of short-term gain. Let us not mistake a favourable bond auction for a new normal. The road ahead is paved with uncertainty, but the direction is clear. Stay the course, and the markets will reward you with lower borrowing costs. Stray, and you will face the wrath of the bond vigilantes. It is that simple, and that hard.
