On Monday morning, as the pound was sliding sharply and interest rates surged, the UK's new prime minister Liz Truss decided to stick with her core instinct: do nothing.
"There was chaos in the markets, but in Number 10 the mood was weirdly calm," says one insider in the Truss camp, after investors slammed the radical tax-cutting budget her government had unveiled three days before.
"She was having meetings on a range of things that had nothing to do with the crisis."
Across town in the City of London, however, many experienced investors were struggling to see how the government would finance the £45 billion ($89b) in tax cuts and some started to smell the beginnings of a financial meltdown.
Luke Hickmore, a fixed income manager at Abrdn who has been investing in UK government bonds for 21 years, says there were periods on Monday and Tuesday when there were no buyers for long-dated gilts (government bonds).
"I've never seen a move like that," he says. Even during the turmoil of the 2008 financial crisis, he adds, there was always a market for gilts.
By Wednesday, as the extreme volatility in the gilts market left some pension funds facing a liquidity crisis, the Bank of England launched a £65b ($129b) emergency intervention. The central bank was in effect being forced to save Britain's economy from the actions of its own government.
Asked only two weeks earlier if she was prepared to be unpopular, Truss replied: "Yes, yes, I am." She has been true to her word. After a week of market turmoil, soaring interest rates and even a stinging public rebuke from the IMF, her political stock is in freefall.
At the start of the week, YouGov had recorded the biggest poll lead by the opposition Labour party over the Tories in two decades: 17 points. By Thursday it had grown to 33 points. Truss, in an excruciating round of local radio interviews, was asked: "Have you slept well?"
"It has become a joke that we're all saying, 'it's going very well, isn't it?'" says one cabinet minister. "We've reached gallows humour already." After Kwasi Kwarteng, the new chancellor, announced his "mini" Budget last week, he chuckled when a colleague said the government was a bit like Millwall football club, whose fans like to chant: "No one likes us: we don't care."
By Friday, there was some respite: although bond yields remain higher, affecting borrowing costs for companies and homeowners, sterling had rebounded to close to its level before last Friday's "mini" Budget. Truss and Kwarteng insist they are sticking to their policy and that it will boost the economy's growth rate.
But the chaotic events of the past seven days raise three questions. How did a G7 economy like the UK find itself the subject of such a ferocious market panic? How did the Conservative party, which was once so closely in tune with the City, end up trying to fight the bond market? And how will the impasse of the past week be resolved?
The confrontation between the Tories and financial markets has been building for some time.
Truss and Kwarteng have long inhabited a world of free market Tory think-tanks, such as the Institute of Economic Affairs, which have nourished a view that Britain is being held back by stale, declinist, economic "orthodoxy".
While previous generations of Tories saw financial markets as being neutral truth-tellers to feckless governments, many on the rightwing of the Conservative party now see the markets as part of a detached elite that does not understand the potential of tax cuts to stimulate growth.
Lord David Frost, former Brexit minister, is among those urging Truss to stand firm against the "ghastly crew" of the economic establishment. In a Friday column in the Daily Telegraph, he listed the IMF, the European Commission, the FT, the Economist and former Bank of England governor Mark Carney as being part of "the international hectoring classes" and insisted the government rejects "that defeatism".
This viewpoint, familiar from the 2016 Brexit debates when "experts" were derided by the Leave campaign, is important in understanding the frame of mind of Truss, as she stuck to her guns through a torrid week.
"There's a mindset, which has been very strong on the right of British politics for many years, which argues that the benefits of supply-side reforms, low taxes and less regulation are immense," says David Gauke, a former cabinet colleague of Truss who is deeply critical of the "mini" Budget.
Gauke argues that Britain's exit from the EU — seen on the Tory right as embodying a hated big-state, big-regulation model — was viewed as a moment of liberation. Now Truss and Kwarteng have had the chance to complete the revolution. "The hypothesis has been tested," says Gauke. "The markets have looked at it and don't believe it."
Even as they have presented a united front over the last week, there have been signs of tensions within the government, including between Truss and her chancellor.
Kwarteng, conscious that market panic risked destabilising the economy, told Truss on Monday that both he and the Bank of England would have to say something to calm nerves. Truss's initial instinct was to say no. "She wanted to ride out the storm," says one. Eventually, the chancellor prevailed.
In a statement issued by the Treasury, Kwarteng in effect acknowledged that he had left the markets "flying blind" — in the words of Tory Treasury committee chair Mel Stride — by not publishing any forecasts or fiscal strategy that would explain his long-term spending plans.
On Friday, the day of his "mini" Budget, Kwarteng told the FT he would produce his new fiscal plan "in the new year". Now, in the face of a massive sell-off of government bonds, he promised on Monday to bring forward new forecasts and a debt plan on November 23.
Behind the scenes, the market ructions were creating enormous stress among some pension funds that had used derivatives to hedge against sharp moves in interest rates and inflation — and suddenly found themselves facing unprecedented margin calls.
Natalie Winterfrost, a professional pensions trustee with Law Debenture, says that conditions in the pension market in the first half of the week were "frantic".
"I was actually at a conference, yet did not get to attend any of the conferences because I was on call after call. When I did pop down for some food, other people also looked shell-shocked," she says. "It was really difficult because we did not know what the next step would be. It really felt like another financial crisis was about to happen."
Calum Mackenzie, a partner at pensions adviser Aon, says he was in a meeting last Friday with a client when he started by explaining how higher bond market yields meant the fund was in a "much, much stronger [position] than they thought".
By the end of the meeting, he says, "the gilt market was apoplectic and was in full sell-off mode after the 'mini' Budget". The pension fund went "into full damage control in a matter of hours", he says.
By Wednesday the Bank of England, which only last week raised interest rates to tame inflation and wanted to sell some of the securities it purchased since the 2008 crisis, was obliged to reverse itself and announce another massive government bond-buying operation in order to stabilise the gilt market.
Simon Hoare, one Tory MP, tweeted: "These are not circumstances beyond the control of Govt/Treasury. They were authored there. This inept madness cannot go on."
On Friday, Kwarteng met the independent Office for Budget Responsibility — another step designed to reassure the market and one reason for the recovery in sterling.
However, for some of his critics, Kwarteng's statements this week are evidence that the government bungled its big economic moment.
According to Stride, the markets were not just spooked by the new borrowing in Kwarteng's statement — including a further £72b ($143b) of new debt by next April — but by the apparently cavalier way in which Kwarteng and Truss have treated the institutions that were supposed to protect the economy from risky political ideas.
During the Tory leadership campaign, Truss criticised the independent BoE, while the sidelining of the OBR removed independent scrutiny from the budgetary process. On his first day as chancellor, Kwarteng sacked the top civil servant at the Treasury, Sir Tom Scholar.
The lack of experience in Number 10 about how to manage economic policy was also glaring to some. "There are too many young people — sycophants," says one minister close to Truss.
Some Tory MPs believe that Truss will fire her old friend and ideological soulmate Kwarteng, although her allies insist that is "absolute nonsense". Yet even among the rightwing MPs who argue that the tax-cutting plan was right, there are some who believe the chancellor's handling of it was clumsy.
One Truss supporter said: "We've been waiting for a real Conservative agenda and now we've blown it for a generation." Gerard Lyons, who has advised Truss on economics told the FT: "You've got to take the markets with you."
Truss, who is still barely known by much of the British public, spent Thursday giving a series of faltering radio interviews — punctuated by cavernous pauses — in which she insisted she would stick to her policy. But if she does not retreat on some of the tax cuts, the markets could force her to confront some highly contentious alternatives.
Stride says one "quick fix" would be to boost economic growth by opening the doors to immigration. However, many Tory MPs oppose that idea: the Brexit vote was, at least partly, about controlling Britain's borders.
Kwarteng is planning tight controls on public spending over five years, even though hospitals and schools are already struggling with the extra costs imposed by higher inflation. Boris Johnson realised that "austerity" was such a toxic concept with voters he refused to use the "A-word".
The chancellor is also considering real terms cuts to benefits. But making such cuts to the income of Britain's poorest people in the middle of a cost of living crisis, while also giving tax cuts to the rich, was described by Gauke as "completely inappropriate, unacceptable and unfeasible".
Truss arrives in Birmingham on Saturday for the annual Tory conference facing questions about her survival as prime minister, less than a month after becoming Tory leader. Some Tory MPs say they cannot vote for the fiscal plan unless it is reformed.
But those inside Downing Street have taken some comfort in a rally in the pound towards the end of the week and insist Truss has not waited this long to implement her political vision only to be blown off course by the markets.
"She's very much not in the mood to budge," says one senior government official. A cabinet minister agrees: "She's absolutely not changing strategy . . . The situation is deadlocked. She can't and won't move." But if Truss cannot show that the sums add up, the markets may yet decide otherwise.
• Additional reporting by Josephine Cumbo, Sebastian Payne and Adrienne Klasa.
Written by: George Parker
© Financial Times
