Liz Truss was defeated by the bond market. Investors aren't satisfied yet

After a bruising three-week battle with bond markets, UK Prime Minister Liz Truss admitted defeat on Friday. She fired her finance minister and gutted her economic program by promising to reinstate a big tax hike on corporations.

Truss said she acted in the national interest to ensure economic stability and to “reassure the markets of our fiscal discipline.” But it remains unclear whether Truss has done enough to persuade skeptical investors, and Friday’s announcement did nothing to calm speculation about whether she can hold on to her job.

The price of 30-year UK government debt, which has been whipsawed in recent weeks, fell after the press conference. The British pound, which had gained ground in recent days on talk of a government rethink, fell 1% to trade at $1.12.

“What the markets want to see is a coherent picture, how it all fits together,” said Charlie Bean, former deputy governor at the Bank of England. “In the absence of that, you’re going to see sterling and gilts coming under pressure again.”

Corporate taxes will rise

Investors rejected an announcement by the Truss government in late September that it would slash taxes while ramping up borrowing in a bid to produce faster growth, citing concerns that the plan would push up inflation just as the Bank of England wants to bring it down. Fears also crept in about the sustainability of government debt at a time of rapidly rising interest rates.

The pound crashed to a record low against the US dollar, while bond prices slumped, sending yields soaring. That pushed mortgage rates much higher, and brought some pensions funds to the brink of default.

The Bank of England was forced to announce three separate interventions to avoid a full-scale meltdown in the UK government bond market.

Truss said Friday that by increasing Britain’s corporation tax from 19% to 25%, the country would raise £18 billion ($20 billion), which she said would “act as a down payment on our full medium-term fiscal plan.”

But the United Kingdom’s credibility won’t be so easily revived.

“The government’s growth agenda is in tatters,” former finance minister Philip Hammond told the BBC. “I’m afraid to say we’ve thrown away years and years of painstaking work to build and maintain a reputation as a party of fiscal discipline and competence in government.”

The market was not assured. In fact, investors continued to openly speculate about whether Truss could remain in her role, even with Jeremy Hunt taking over as finance minister.

“Markets are crying out for more to be done for confidence in the UK government to be restored,” Paul Dales, chief UK economist at Capital Economics, said on a call with clients. “Getting rid of Truss, I think, would be one way of doing that.”

Truss has said she’s serious about limiting UK government debt as a share of economic activity, but the numbers don’t add up. About £25 billion ($28 billion) worth of new tax cuts remain in play, on top of the huge cost of winter energy subsidies. Stabilizing the debt-to-GDP ratio by 2024-2025 still looks out of reach, according to Capital Economics.

That’s putting investors on edge, especially since more details on the revised Truss plan aren’t formally expected until Oct. 31. Bean thinks that date, which was already brought forward, may need to be moved up again.

“As far as the markets are concerned, they want to see a substantive change in direction,” he said.

The government said Friday that Hunt was sticking with his predecessor’s Halloween timetable.

Bryn Jones, head of fixed income at Rathbones, said his team bought longer-dated UK government bonds this week. They benefited as prices rose in anticipation of the U-turn. On Friday, however, they sold those holdings, opting to take a profit.

“Buy the rumor, sell the fact,” Jones said, citing a well-worn adage among investors.

What happens next

As investors digest the latest developments, government policymakers and the Bank of England will be on notice.

The central bank is on particularly high alert given that its program to buy up to £65 billion in bonds — announced on Sept. 28 — ended on Friday. Bank of England Governor Andrew Bailey said earlier this week that it would not be extended.

The central bank scooped up nearly £19.3 billion ($21.5 billion) worth of bonds through Friday. That’s well below what it could have purchased. But its willingness to act as a buyer of last resort has served as a balm for markets, and it’s not clear if angst will return once it steps back.

Global dynamics could also make it more difficult for UK markets to find their footing even as the government backtracks.

As high inflation persists, driving uncertainty about how much further interest rates will have to rise, many investors are choosing to hold cash instead of debt. Their decision to sit on the sidelines is exacerbating swings in the bond market at a delicate moment.

“I would expect the liquidity challenges to persist,” said UBS strategist Rohan Khanna. “I don’t think they’re going away that quickly.”

Traders and regulators will be monitoring how the coming days unfold. So too will politicians, with many whispering that unless the situation in markets steadies soon, Truss could be running on borrowed time.

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