Demand for UK sovereign debt took a bath yesterday

Outlook:

Yields, or rather relative yield differ entials, are not the only deter minant of a currency's level but can be a big factor. The "uncovered interest parity" theory has it that all interest rates everywhere start out the same and the only reason for one to rise or fall against the others is the expectation of a change in the exchange rate. Because the prices of real goods are slow to respond to the exchange rate change expectation, the currency will always overshoot, then retreat when it's seen as inappropriate, but return to the trend direction of the overshoot in the end.

This is the Dornbusch overshooting thesis and it has been widely accepted since 1976. We make fun of it a little in The FX Matrix, but once you accept the starting premise, the logic is pretty good and helpful in a case like the UK. Because real output is constrained in the short-term—it takes time to build factories and train workers—the only way for yield to fall is if the currency appreciates. But wait a minute— if easy monetary policy is raising money supply, the exchange rate should depreciate proportionately. And indeed the currency will initially depreciate, swing back, and then depreciate more to return the bond market to equilibrium with the rest of the world.

In practice, of course, we never actually get equilibrium, the economist's fiction. We say this is because of political and institutional risk, which in the case of the euro is reflected in the extreme commitment to prevent inflation. The euro can get away with lower yields because the world has confidence that it will not depreciate on account of inflation. The US is thought to have a lesser commitment, having added full employment to the central bank mandate, and so the US must offer a yield premium over the Bund.

Now apply the model to the UK. The problem is that real economic variables are slow to respond to financial conditions while financial markets move like the wind. As we know, data since Brexit show the UK economy as more resilient than we thought. So far the giant sterling depreciation on the Brexit vote, while a Shock, has yet to be reflected in the underlying economy. Last week we saw sterling put in another bout of depreciation on the prospect of a "hard Brexit," meaning the UK gets no trade concessions from the EU in the end. It's premature to accept this, of course, but the market was willing to jump to that conclusion, especially after PM May spoke of making the economy more "fair" and other related ideas about dropping some (if not all) of the Tories' austerity and budget-balancing commitments.

Flash crash aside—and we imagine it really was an error and not something nefarious—sterling "deserves" to fall more to reflect what will become of the economy once it's outside the EU. But wait a minute—why did yields suddenly go over 1% yesterday? Bonds are a real pain to think about. A rise in yields means a fall in price, and prices fall on a drop in demand. Demand for UK sovereign debt took a bath yesterday, driving the yield up. If the financial world thinks sterling must depreciate some more to reflect economic expectations, then yields must rise to equilibrate.

Economists everywhere are using the uncovered interest parity model to forecast the pound. In Norway, according to Reuters, a senior sovereign fund economist says sterling devaluation, including the flash crash, are the "correct" moves, economically speaking, that reflect expectations. The Fund seeks to benefit from investment in freely-moving goods, services and people. The UK will likely not remain the second biggest component in the Fund's portfolio. Meanwhile, big bank CEO's are preparing contingency plans ahead of Article 50, to be invoked by March 31. The Citibank guy last week said jobs will be moving out of London regardless of what deals are made on things like passporting. Today it was the CEO of Morgan Stanley predicting an outflow of financial sector jobs.

And today we have a remarkable statement from BoE policy member Saunders, who says it will be no surprise if sterling falls some more but the Bank can overlook the inflation effect, perhaps for years, because the current account effect is more important. Kashyap, another member, from the Chicago School, predicts sterling falls more if the outcome is a "hard Brexit." Reuters reports he says it wouldn't take a big job loss in the financial service sector to "knock a hole in its government finances." The market knew exactly what to do with this information—sterling extended losses even as Kashyup was still speaking.

All this heavy breathing is due mostly to PM May sounding too much like rushing into a hard Brexit, i.e., not getting concessions on trade from the EU because of too strong a stand on immigration and refugees. In other words, it was May's rhetoric and not anything resembling hard news that has flipped the switch. Turning back the clock now seems unlikely. In fact, the latest from May's office pertains to the City hiring more women, a useful initiative but not the best timing if we are measuring priorities. May is making a mistake if she thinks the financial sector is giving to give up the bone it's chewing on right now. Markets are Dobermans, not poodles.

The risk is of a crisis in confidence that leads to a crisis in flows. The UK absolutely, positively needs capital inflow to offset the giant current account balance. If confidence collapses—and we have seen it before in the UK—sterling crashes some more and the yields on Gilts will soar. Then the BoE will really be in a pickle. Or maybe it's just a temper tantrum over the prospect of Article 50 by March 31. Stay tuned.

Elsewhere in the world, the US easing season starts today with the usual suspect, Alcoa, reporting its last earnings before being split up. Some critics believe the US market is overvalued and even a bubble on the basis of P/E's being historically high. Well, maybe. Until the new higher yields get a grip, we wouldn't be too sure of that.