How We Got Here: The UK Financial Crisis

The appointment of Rishi Sunak as prime minister on October 25 marked another rapid development in a tumultuous period for the UK government. Rishi Sunak replaces Liz Truss, who resigned on October 24 following a self-imposed financial crisis. At a time of surging inflation and a European energy crisis, Liz Truss’ ill-fated PM tenure was brief– the shortest in British history – but highly consequential. 

As the UK political environment evolves rapidly, let’s review how we got to this historic and precarious moment in the UK’s economy. 

In July, then-PM Boris Johnson resigned, having lost the confidence of the Conservative Party amid a series of scandals. Two candidates emerged to replace him, each with opposing views on combating the rise in cost of living. Liz Truss favored an immediate tax cut, while her opponent, former finance minister Rishi Sunak, argued that immediate cuts would fuel further inflation. Liz Truss won the Conservative Party member vote and took power on September 6.

Announcement of the “Mini-Budget” 

On September 23, the new administration’s first major policy decision abruptly set off a crisis. Chancellor Kwasi Kwarteng announced substantial interventions to address energy prices, at a price tag of 60 billion pounds, and a series of massive tax cuts, reducing taxes for top earners while abandoning planned tax increases for corporations. Importantly, the cost of the new scheme, referred to as the mini-budget, was to be funded through increased government borrowing.

Markets immediately reacted to the chancellor’s announcement. Yields on UK gilts (government-issued bonds analogous to US Treasuries) soared as investors dumped the bonds. The sterling plunged against the US dollar. This sudden and drastic reaction was primarily due to a few self-inflicted missteps.

Rushed Policies and a Crisis in Confidence

At the time of the announcement, the government curiously did not provide independent growth and borrowing forecasts from the Office for Budget Responsibility, raising concerns about the government’s due diligence and fiscal credibility.  

Additionally, the day before the mini-budget announcement, the Bank of England (BoE) increased rates amid its ongoing fight against inflation, a move intended to dampen demand, seemingly in contrast to the mini-budget’s tax-cutting strategy. As it raised rates, the BoE also announced the commencement of the sale of UK government bonds from its balance sheet, increasing gilt supply.

The UK gilt market is not as deep or liquid as the US Treasury market, so it is more susceptible to supply shocks. With a lack of buyers to absorb the increase in anticipated government borrowing, gilt prices plummeted and yields spiked. Leveraged pension schemes were forced to sell gilts amid margin calls, adding to the bond market spiral. The flight to cash contributed to the sterling’s historical decline against the US dollar. To calm the market, the BoE reversed course, delaying gilt sales and implementing an emergency 65 billion pound bond buying program to stabilize markets.

The Political Fallout and What’s Ahead

The crisis led to a lack of confidence in the government’s ability to implement new policies. Chancellor Kwasi Kwarteng resigned, replaced by Jeremy Hunt, who reversed many of the policies announced in the mini-budget. Other administration departures followed, culminating in the resignation of Liz Truss.

The change in administration has helped stabilize the gilt market, and yields have moderated from their peak, but macroeconomic problems will not be easy for new PM Rishi Sunak to overcome. As a net importer of energy and other goods, the UK faces economic headwinds, hamstrung with high borrowing costs and high inflation. The government must reestablish stability and forge a path for growth, while BoE needs to reestablish credibility in its independence and fight against inflation. The BoE is expected to raise rates again in Q4, though another rate hike is unlikely to quell inflation on its own. While the gilt market has calmed and trading volume has declined since the start of the crisis, bid-ask spreads remain wide as investors look toward the new administration’s future plans with caution.