The market sell-off that followed the publication of the UK government’s budget plan extended into another week, increasing pressure on the secular administration of Liz Truss.
Kwasi Kwarteng’s all-out bet on tax cuts and additional borrowing to stimulate the economy sparked a fierce and damaging assessment from investors on Friday that sent British assets tumbling. Seemingly unfazed by the response, Chancellor promised even more tax cuts this weekend.
When markets reopened in Asia on Monday, the crisis showed few signs of abating, as the beleaguered pound fell to a new 37-year low against the dollar. If the rout continues to deepen as traders continue to deliver their verdict in real time this week, the selloff risks escalating from a short-term embarrassment for the government to a deeper crisis that may require a quick policy response. .
With the pound sliding as much as 0.9% below $1.08 on Sunday evening, the gilt market opening at 8am on Monday will also be one to watch.
“With large unfunded fiscal spending without a monetary policy counterpart to offset the inflationary impulse, the currency is likely to weaken further,” Goldman Sachs analysts including Kamakshya Trivedi wrote in a note to clients on Friday.
In a sign of the historic severity of Friday’s selloff, the pound was at one point on its worst day against the dollar since the record crash following the Brexit vote in 2016. In the end, the 3.6% drop was the seventh worst. over the past 50 years. At the same time, government bond yields soared, by record highs on some maturities, as investors punished the Chancellor for his shameless dash For growth.
If sustained, the movement in yields will significantly inflate the cost of the additional £400bn ($434bn) of borrowing that the Resolution Foundation estimates is needed over the next five years to fund the plan , adding to an already inflated interest bill thanks to heaven-high inflation and bank of england rate increases.
Market moves this week could have huge implications. The Telegraph reported on Saturday that Truss face a rebellion Tory backbenchers against his tax cuts if the pound falls to parity with the dollar. Meanwhile, some in the markets are already claiming BOE emergency action to stem the tide, an action unprecedented in modern times that would risk adding to the feeling of panic.
Former BOE official Adam Posen said Twitter that he expects Bailey to “say publicly by the middle of the week that if the GBP goes down, rates go up”. He also raised the possibility of Treasury intervention to support the pound on Sunday ahead of the open, but others underline that Britain’s foreign exchange reserves are only a fraction of those of Japan, which pursued the same policy last week.
If the weekend break has brought some calm and the moves start to return on Monday, it will give Truss and Kwarteng time to try and get back on the agenda. It would heighten the importance of the Conservative Party conference early next month, which now risks turning from a crowning of the new government into a chance to restore already battered credibility.
But the outlook for many in the market is far from rosy. Last week’s turmoil led to other predictions, including from former US Treasury Secretary Lawrence Summers, that the pound would fall below parity with the dollar. Bloomberg’s option pricing model now shows a one-in-four chance of the pound hitting $1 in the next six months, up from 14% on Thursday.
Others are expressing concerns about the future of UK debt. Worryingly, central bank support through quantitative easing, once a savior for gilts, has now been reversed by officials seeking to contain runaway price gains.
“The gilt market is adjusting to a seismic shift in the fiscal landscape and a gigantic supply and demand outlook,” HSBC analysts wrote in a note Friday. “The return of large-scale borrowing of this nature comes at the same time as the BOE also transitions from a buyer to a seller of bonds, and – more importantly – other investors are increasingly concerned about the UK fiscal credibility.”
After Kwarteng’s speech on Friday, the pound crashed, yields on 10-year debt rose more than 30 basis points to 3.83% and the rate on five-year notes jumped a record high of 51 basis points.
Meanwhile, traders fully priced 120 basis points of additional rate hikes from the BOE at its Nov. 3 meeting — more than double the size of the move announced Thursday that took rates to 2. 25%. Traders are also now pricing in the possibility of an intra-meeting upside, according to Trevor Pugh, head of inter-dealer broker gilt and agency offices at Tradition Ltd.
After the event, the new chancellor denied that investors were panicking, telling the Financial Times that “markets move all the time – it’s very important to keep calm and focus on the longer-term strategy”.
For now, market sentiment on this strategy seems weak.
“Unless something can be done to address these fiscal concerns, or the economy shows surprisingly strong growth data, it looks like investors will continue to steer clear of the pound,” Antoine Bouvet and ING’s Chris Turner. “Given our bias for the dollar rally to also get carried away, we think the market may be undervaluing the chances of parity.”
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