British Prime Minister Liz Truss and British Chancellor of the Exchequer Kwasi Kwarteng.
Dylan Martinez | AFP | Getty Images
LONDON – The first fiscal policy announcement of new British Prime Minister Liz Truss’ government has come up against one of the sharpest market selloffs in recent history.
The Pound sterling reached a historic low against the dollar in the early hours of Monday morning, falling below $1.04, while the UK 10-year gilt yield hit its highest level since 2008 as disarray continued after Finance Minister Kwasi Kwarteng’s “mini-budget” on Friday.
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The pound rallied slightly to trade around $1.078 Tuesday morning. The bank of england said Monday afternoon that it was monitoring of market developments and would not hesitate to raise interest rates in order to bring inflation back towards its target of 2% in the medium term.
Jim O’Neill, former chairman of Goldman Sachs Asset Management and former UK Treasury minister, said the pound’s fall should not be misinterpreted as dollar strength.
“It is the consequence of an extremely risky budget by the new Chancellor and a rather timid Bank of England which, so far, has only reluctantly raised rates despite all the obvious pressures,” he said. he told CNBC on Monday.
Friday’s announcement featured a volume of tax cuts not seen in Britain since 1972 and a shameless return to the “trickle down economy” promoted by the likes of Ronald Reagan and Margaret Thatcher. The sweeping policy measures have put the UK at odds with most major global economies amid the skyrocketing inflation and one cost of living crisis.
The budget package – which includes around £45bn in tax cuts and £60bn in energy support for households and businesses over the next six months – will be financed by borrowing, at a time when the bank of england plans to sell £80bn worth of gilts over the coming year to reduce its balance sheet.
The rise in 10-year gilt yields above 4% could suggest that the market expects the Bank to raise interest rates more aggressively in order to contain inflation. The 10-year gilt yield has risen 131 basis points so far in September – on track for its biggest monthly rise on record in Refinitiv and Bank of England data dating back to 1957, according to Reuters .
Truss and Kwarteng argue their sole aim is to spur growth through tax and regulatory reform, with the new finance minister suggesting in a BBC interview on Sunday that more tax cuts could be on the way. However, the plan has drawn criticism for disproportionately benefiting those with the highest incomes.
The Independent Institute for Fiscal Studies also accused Kwarteng of playing on the UK’s fiscal sustainability to push through huge tax cuts ‘without even a semblance of an effort to drive up public finance figures’ .
As the markets continue to oppose the plans of the new prime minister, Sky News reported on Monday morning that some Tory MPs are already submitting letters of no confidence in Truss – just three weeks into her term – citing fears she is “crushing the economy”.
Vasileios Gkionakis, Head of European Currency Strategy at Towntold CNBC on Monday that the massive fiscal stimulus and tax cuts, financed by borrowing at a time when the Bank of England embarks on quantitative tightening, amounted to an “erosion of confidence” in the market in the UK as a sovereign issuer, leading to a “textbook currency crisis”.
He argued that there is “no empirical evidence” behind the government’s claim that expanding fiscal policy in this way will boost economic growth, and suggested that the likelihood of higher emergency rates between Bank of England meetings were rising.
“That being said, for it to provide at least significant temporary relief, it would need to be material, so my best guess is that it would need to be at least 100 basis points of an upside “, said Gkionakis, adding that this may lead to a sterling recovery.
“But make no mistake, another 100 basis points is going to send the economy into a tailspin, and will end up being negative for the exchange rate, so we’re in this situation right now where the pound has to depreciate further. to compensate investors for the UK’s higher risk premium.”
The prospect of further acceleration in the Bank of England’s monetary policy tightening was a recurring theme for analysts on Monday.
“These fiscal developments imply that the BoE will now have to tighten policy more aggressively than it otherwise would have in order to counter additional price pressures resulting from fiscal stimulus,” said Roukaya Ibrahim, vice chairman of BCA Research, in a research note. Monday.
“While rising bond yields generally support the currency, the pound’s selloff shows market participants are skeptical of foreign investors’ willingness to fund the deficit amid a lackluster domestic economic backdrop.”
Ibrahim added that this would mean further pain for UK financial markets due to the “unfavorable policy mix” in the short term.
Additional details expected
Much of the market shock came from the scale of the tax cuts and the lack of offsetting revenue or spending measures, which raised concerns about fiscal strategy and the mix of country’s policies, according to Barclays Fabrice Montagne, UK Chief Economist.
The British lender expects the government to clarify its plans to balance the books through “spending cuts and reform outcomes” ahead of the November budget statement, which Montagne says “should help dispel concerns.” immediate concerns related to the large unfunded tax cuts”.
Barclays also expects the government to launch an energy conservation campaign over the next month, aimed at facilitating demand destruction.
“Taken together, we believe fiscal consolidation and energy conservation should help contain domestic and external imbalances,” Montagne said.
However, against a backdrop of tight supply, a tight labor market and near double-digit inflation, Montagne suggested that even the smallest positive demand shock could trigger huge inflationary consequences.
This could lead the Bank of England to propose a 75 basis point interest rate hike in November once it fully assesses the effect of fiscal measures, he said.
A possible mitigating factor, Montagne noted, is that while the UK’s trade performance may be dismal and its deficit large, the fact that the country is borrowing domestically and investing abroad means that its external position is weakening. improves when the currency depreciates.
“Although public debt levels are high, fiscal sustainability measures are not much different from their counterparts, in some cases even better. In our view, this should alleviate immediate concerns about the risks of a crisis. balance of payments,” he said.
Barclays does not see UK economic fundamentals calling for a stronger rise than the bank’s new core expectations of 75 and 50 basis points at the next two meetings, and does not expect the MPC proposes an emergency hike between meetings, but instead to wait until November to revise its narrative in light of new macroeconomic projections.
“Similarly, we do not expect the government to backtrack at this stage. On the contrary, as mentioned above, we expect it to move forward by accelerating structural reforms and spending reviews, in an effort to deflect immediate market concerns,” Montagne added. .